AAFM Financial Derivatives and Alternative Investments 1 — Questions and Answers
Question 1: A call option gives the holder the right, but not the obligation, to do which of the following?
- Sell the underlying asset at the strike price
- Buy the underlying asset at the strike price (Correct answer)
- Receive a fixed dividend
- Borrow at the risk-free rate
Correct answer: Buy the underlying asset at the strike price
A call option grants the buyer the right to purchase the underlying asset at the agreed strike price before or on the expiration date, regardless of the current market price.
Question 2: In options pricing, the Black-Scholes model uses which five inputs to determine the theoretical value of a European option?
- Price, volume, dividend yield, beta, and maturity
- Stock price, strike price, risk-free rate, time to expiration, and volatility (Correct answer)
- Price, earnings, debt, cash flow, and growth rate
- Market cap, beta, dividend, PE ratio, and yield
Correct answer: Stock price, strike price, risk-free rate, time to expiration, and volatility
The Black-Scholes model requires the current stock price, option strike price, risk-free interest rate, time to expiration, and the underlying asset's volatility to compute a European option's fair value.
Question 3: A futures contract obligates both parties to transact an asset at a predetermined price on a specified future date, unlike which related instrument?
- Forward contract
- Swap agreement
- Options contract (Correct answer)
- Swaption
Correct answer: Options contract
Unlike futures, options give the buyer the right but not the obligation to transact, while futures require both the long and short parties to fulfill the contract at maturity.
Question 4: Which risk measure in options, delta, represents the sensitivity of an option's price to a change of what?
- Time to expiration
- Implied volatility
- The underlying asset's price (Correct answer)
- The risk-free rate
Correct answer: The underlying asset's price
Delta measures how much an option's price changes for a $1 change in the price of the underlying asset, ranging from 0 to 1 for calls and -1 to 0 for puts.
Question 5: A hedge fund strategy that profits from pricing discrepancies between related securities, regardless of market direction, is classified as which type?
- Long/short equity
- Global macro
- Market neutral/arbitrage (Correct answer)
- Managed futures
Correct answer: Market neutral/arbitrage
Market-neutral and arbitrage strategies seek to profit from relative mispricings between related instruments while hedging out directional market risk, producing returns uncorrelated with broad markets.
Question 6: Private equity buyout funds typically use which financial technique to amplify returns by using borrowed capital to finance acquisitions?
- Short selling
- Leveraged buyout (LBO) (Correct answer)
- Currency hedging
- Mezzanine financing
Correct answer: Leveraged buyout (LBO)
A leveraged buyout (LBO) finances the majority of an acquisition with debt, allowing the private equity fund to control a large asset with limited equity, amplifying returns if the business performs well.
AAFM Financial Derivatives and Alternative Investments 1
A call option gives the holder the right, but not the obligation, to do which of the following?