CSC - Canadian Securities Course Derivatives and Risk Management Questions and Answers — Questions and Answers
Question 1: An investor purchases a call option on XYZ stock with a strike price of $50 for a premium of $3 per share. At the time of expiry, XYZ stock is trading at $58. What is the intrinsic value of the option per share?
- $5
- $8 (Correct answer)
- $3
- $0
Correct answer: $8
The intrinsic value of a call option is the amount by which the underlying stock's price is above the strike price. It is calculated as: Market Price - Strike Price. In this case, $58 - $50 = $8. The premium paid ($3) is not part of the intrinsic value calculation, but it does affect the overall profit/loss of the position.
Question 2: Which of the following BEST describes a key difference between a forward contract and a futures contract?
- Futures contracts are customized agreements, while forward contracts are standardized.
- Forward contracts are traded on an exchange, whereas futures contracts are traded over-the-counter (OTC).
- Forward contracts are marked-to-market daily, while futures contracts are settled only at maturity.
- Futures contracts have standardized terms and are traded on an exchange, minimizing counterparty risk. (Correct answer)
Correct answer: Futures contracts have standardized terms and are traded on an exchange, minimizing counterparty risk.
Futures contracts are standardized in terms of quantity, quality, and delivery date, and are traded on formal exchanges with a clearinghouse that guarantees performance, thus minimizing counterparty (default) risk. In contrast, forward contracts are customized, private agreements traded over-the-counter (OTC), which exposes the parties to higher counterparty risk.
Question 3: A portfolio manager is concerned about rising interest rates negatively impacting the value of a fixed-rate bond portfolio. To hedge this risk, the manager could enter into an interest rate swap. Which position should the manager take in the swap?
- Pay a floating rate and receive a fixed rate.
- Pay a fixed rate and receive a floating rate. (Correct answer)
- Pay a floating rate and receive a floating rate.
- Pay a fixed rate and receive a fixed rate.
Correct answer: Pay a fixed rate and receive a floating rate.
To hedge against rising interest rates on a fixed-rate asset portfolio, the manager wants to convert the fixed-rate cash flows into floating-rate ones. By entering a swap where they pay a fixed rate and receive a floating rate, the floating payments received will increase as interest rates rise, offsetting the decline in the value of the fixed-rate bonds.
Question 4: An investor who is bullish on a stock believes its price will rise significantly. Which of the following option strategies offers limited risk and unlimited potential profit?
- Writing (selling) a call option
- Buying a put option
- Writing (selling) a put option
- Buying a call option (Correct answer)
Correct answer: Buying a call option
Buying a call option gives the investor the right, but not the obligation, to buy the stock at a predetermined price. If the stock price rises, the potential profit is theoretically unlimited. If the stock price falls, the maximum loss is limited to the premium paid for the option.
Question 5: Which of the following scenarios describes the primary motivation for a speculator using derivatives?
- A corn farmer selling corn futures to lock in a price for their upcoming harvest.
- A Canadian exporter buying a currency forward to hedge against a rise in the Canadian dollar.
- An investor buying S&P/TSX 60 Index futures because they believe the overall market is undervalued and will rise. (Correct answer)
- A corporation entering an interest rate swap to convert its variable-rate debt to a fixed rate.
Correct answer: An investor buying S&P/TSX 60 Index futures because they believe the overall market is undervalued and will rise.
Speculation involves using derivatives to profit from an anticipated change in the price of an underlying asset, without having a direct offsetting business risk to hedge. Buying index futures based on a belief that the market will rise is a clear example of speculation. The other options describe hedging, which is the practice of using derivatives to reduce or eliminate an existing risk.
Question 6: The premium of an option is composed of its intrinsic value and its time value. If a put option is 'at-the-money,' what constitutes its entire premium?
- Intrinsic value only
- Neither intrinsic value nor time value
- Time value only (Correct answer)
- An equal combination of intrinsic and time value
Correct answer: Time value only
An option is 'at-the-money' when its strike price is equal to the current market price of the underlying asset. In this case, the intrinsic value (the value if exercised immediately) is zero. Therefore, the entire premium of an at-the-money option consists of its time value, which reflects the possibility that the option will become in-the-money before it expires.
CSC - Canadian Securities Course Derivatives and Risk Management Questions and Answers
An investor purchases a call option on XYZ stock with a strike price of $50 for a premium of $3 per share.
At the time of expiry, XYZ stock is trading at $58.
What is the intrinsic value of the option per share?