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CHAPTER 13: ADVANCED DERIVATIVES AND STRATEGIES
MULTIPLE CHOICE TEST QUESTIONS
Answer questions 1 through 6 about insuring a portfolio identical to the S&P 500 worth $12,500,000 with a three–
month horizon. The risk-free rate is 7 percent. Three-month T-bills are available at a price of $98.64 per $100 face
value. The S&P 500 is at 385. Puts with an exercise price of 390 are available at a price of 13. Calls with an exercise
price of 390 are available at a price of 13.125. Round off your answers to the nearest integer.
1. What is the minimum value of the insured portfolio?
a. $16,672,344
b. $12,500,000
c. $12,091,709
d. $12,244,898
e. $13,375,000
2. How many puts should be used to insure this portfolio?
a. 122,584
b. 31,397
c. 62,814
d. 961,538
e. 32,468
3. If the S&P 500 ends up at 401, determine the upside capture.
a. 96.7 percent
b. 96 percent
c. 99.3 percent
d. 94 percent
e. 100 percent
4. If the insured portfolio consisted entirely of calls and T-bills, how many would be used?
a. 19,143 calls and 124,176 T-bills
b. 31,397 calls and 122,449 T-bills
c. 933,238 calls and 2,547 T-bills
d. 31,407 calls and 119,997 T-bills
e. 32,468 calls and 32,468 T-bills
5. If the insured portfolio were dynamically hedged with stock index futures, how many futures would be used?
The call delta is 0.52 and the continuous risk-free rate is 5.48 percent. Each futures has a multiplier of 250 and
a price of 777.30.
a. 60
b. 64
c. 30
d. 32
e. none of the above
6. If the insured portfolio were dynamically hedged with T-bills, how many T-bills would be used?
a. 16,332
b. 63,002
c. 126,723
d. 61,672
e. 32,468
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7. Suppose a firm offers an equity-linked security. The face value is $1 million and its payoff is based on any
appreciation in an equity index currently at 855.50. It has determined that of the $1 million raised, it can
structure the option component so that its value is $135,000. Currently an at-the-money call option is worth
$125. What percentage of the gain in the index can it offer?
a. 92 percent
b. 100 percent
c. 50 percent
d. 8.23 percent
e. none of the above
8. Weather derivative payoffs can be based on each of the following variables except
a. temperature above a given level
b. inches of snowfall
c. total value of insurance claims
d. temperature below a given level
e. sunshine
9. Which of the following statements about mortgage-backed security strips is true?
a. both interest-only and principal-only strips are subject to pre-payment risk
b. only principal-only strips are subject to prepayment risk
c. only interest-only strips are subject to prepayment risk
d. the prepayment risk of interest-only and principal-only strips is precisely offsetting
e. none of the above
10. A chooser option is similar to what other type of option strategy
a. put-call parity
b. a covered call
c. a protective put
d. a combination bull and bear spread
e. none of the above
11. The number of possible final average prices in an Asian option for a four period binomial model is
a. 8
b. 4
c. 16
d. 32
e. none of the above
12. A lookback call option provides the right
a. to change the stock on which the option is written
b. to buy the stock at its lowest price over the option‘s life
c. to insure a stock against loss
d. to change your mind about the exercise price
e. none of the above
13. If the stock price is currently 36, the exercise price is 35 and the stock ends up at 44, the value of an asset–or–
nothing option at expiration is
a. 35
b. 8
c. 9
d. 44
e. none of the above
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14. The primary problem in pricing electricity derivatives is that
a. the volatility cannot be measured
b. the underlying asset cannot be stored
c. electricity is a homogeneous product
d. the demand for electricity is unpredictable
e. the electricity market is unregulated
15. An equity forward contract is
a. a forward contract on LIBOR secured by a stock as collateral
b. a futures contract on a stock index that is not marked-to–market
c. a call option on a stock with greater downside risk than an ordinary call
d. a forward contract whose payoff is determined by a stock or index
e. none of the above
16. A security that pays off the return from a combination of mortgages is called a
a. homeowners’ equity claim
b. mortgage portfolio
c. mortgage option
d. mortgage-backed security
e. none of the above
17. Asian options are also called
a. average price options
b. Pacific options
c. installment options
d. no-regrets options
e. none of the above
18. Which of the following statements is correct about cash-or-nothing options
a. they are subject to no credit risk
b. they must be priced by the binomial model
c. they have lower upside gains and lower downside losses than ordinary options
d. they are equivalent to short positions in asset–or-nothing options
e. none of the above
19. A constant maturity swap has which of the following characteristics
a. the swap maturity is held constant at a fixed number of years
b. the floating payment is usually based on the rate on a Treasury note
c. the swap calls for all payments to be made at its maturity
d. the floating payment and the maturity are both constant
e. none of the above
20. A range floater is a security with which of the following characteristics
a. the payments range from a given maximum to a given minimum
b. the maturity is limited to a fixed range
c. its payments are based on whether the rate stays within a range
d. all of the above
e. none of the above
21. A security that is sub-divided into securities called tranches is called a
a. principal-only strip
b. asian lookback option
c. range mortgage strip
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d. collateralized mortgage obligation
e. none of the above
22. Which of the following is a path-independent option
a. a fixed strike Asian call option
b. a standard European call option
c. an up-and-out call option
d. an American put option
f. none of the above
23. In a weather derivative, the number of days times the average temperature above 65 degrees Fahrenheit is
called
a. temperature day count
b. day-temps
c. cooling degree days
d. temp-days
e. heating degree days
24. A contingent-pay option is replicated by which of the following combinations?
a. long an ordinary call and long an ordinary put
b. long an ordinary call and short a cash–or-nothing call
c. long an ordinary call and short an asset-or-nothing call
d. long an ordinary call and long an equity forward
e. long an ordinary call and long a risk-free bond
25. Which of the following is not a type of structured note?
a. range floater
b. inverse floater
c. diff floater
d. reverse floater
e. none of the above
26. When pursuing portfolio insurance of a stock position, the minimum value of the portfolio is equal to
a. zero
b. strike price times the number of shares of stocks and puts held
c. strike price divided by the number of shares of stocks and puts held
d. stock price times the number of shares of stocks held
e. strike price times the initial value of the portfolio divided by the stock price minus the put price
27. Upside capture is defined as the
a. dollar value of the uninsured portfolio value minus the insured portfolio value
b. percentage of the insured portfolio value that is represented by the uninsured portfolio value
c. dollar value of the insured portfolio value minus the uninsured portfolio value
d. percentage of the uninsured portfolio value that is represented by the insured portfolio value
e. put premium as a percentage of the original portfolio value
28. Identify the false statement related to break forward contracts.
a. It is a combination of spot and derivative positions that replicates an ordinary call option.
b. The initial positions are structured so that the overall position costs nothing up front.
c. Penalizes the investor if the option ends up out-of–the-money.
d. Break denotes the ability of the purchaser to void the contract.
e. All of the above statements are true related to break forward contracts.
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29. Digital options can be used to synthetically create a position in an underlying instrument by
a. purchasing a cash-or–nothing digital put and selling an asset-or-nothing digital call
b. purchasing both a cash–or-nothing digital call and a cash–or-nothing digital put
c. purchasing both an asset–or-nothing digital call and an asset-or–nothing digital put
d. purchasing a cash-or–nothing digital call and selling a cash-or–nothing digital put
e. purchasing an asset–or–nothing digital call and selling an asset-or-nothing digital put
30. Digital options can be used to synthetically create a position in a zero coupon bond by
a. purchasing a cash-or–nothing digital put and selling an asset-or-nothing digital call
b. purchasing both a cash-or-nothing digital call and a cash-or–nothing digital put
c. purchasing both an asset–or-nothing digital call and an asset-or–nothing digital put
d. purchasing a cash-or–nothing digital call and selling a cash-or–nothing digital put
e. purchasing an asset–or-nothing digital call and selling an asset-or–nothing digital put
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CHAPTER 13: ADVANCED DERIVATIVES AND STRATEGIES
TRUE/FALSE TEST QUESTIONS
T F 1. The cost of a break forward contract is a result of the possibility of having a negative value
at expiration.
T F 2. One attractive feature of weather as the underlying in a derivative is that it is easily
measurable.
T F 3. If you buy an asset–or-nothing option and a cash-or–nothing option, you hold the equivalent
of an ordinary European option.
T F 4. Barrier options either begin or end when the stock hits a certain price.
T F 5. A chooser option permits you to choose the exercise price at a later date before expiration.
T F 6. An inverse floater shortens its maturity when the underlying rate hits a certain level.
T F 7. A diff swap pays off in one currency based on the difference between two interest rates
from different countries.
T F 8. An option to buy an option is called a compound option.
T F 9. Asian options provide the right to give up U.S. dollars and receive an Asian stock return.
T F 10. In practice portfolio insurance strategies are usually executed using put options.
T F 11. The cost of portfolio insurance is the return foregone if the market moves up.
T F 12. Portfolio insurance using stock and T-bills is less expensive than using stock and puts.
T F 13. Equity-linked debt is equivalent to a zero coupon bond and a given number of call options.
T F 14. The Black-Scholes model is not appropriate for pricing electricity derivatives.
T F 15. Interest-only strips lose the some or all of the end of their stream of cash flows if
prepayment occurs.
T F 16. A quanto is a derivative involving two currencies in which the payoff is based on a fixed
exchange rate.
T F 17. A contingent-pay option allows the holder to decide at expiration if he or she wants to pay
for it.
T F 18. Large stock price moves reduce the effectiveness of portfolio insurance.
T F 19. A PO is a security promising a stream of common stock dividend payments.
T F 20. Path-dependent options have payoffs that cannot be determined without examining exactly
how the asset moved during the life of the option.
T F 21. Modified lookback options fix the exercise price and replace the expiration price of the
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asset with the maximum or minimum price.
T F 22. A standard (Black-Scholes) European option is equivalent to a combination of a down-and-
out call plus a down-and-out put.
T F 23. Mortgage-backed securities are widely used to make home ownership more affordable.
T F 24. Because a chooser option enables the holder to end up with either a put or a call, it is
equivalent to a straddle.
T F 25. The rate on a constant maturity swap is based on a U. S. Treasury security of a given
maturity.
T F 26. The upside capture measure is always less than one hundred percent.
T F 27. The opportunity cost of portfolio insurance is the difference in the value of the insured
portfolio and the value of the uninsured portfolio when the market goes up.
T F 28. Dynamic hedging can be performed by using stock and risk-free debt to achieve portfolio
insurance by setting the delta of the stock-debt combination to the delta of a combination of
stock and puts.
T F 29. Warrants have been around much longer than exchange-listed options.
T F 30. Range floaters pay interest only if a specified interest rate falls outside of a given range.
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