Stock Institutions and Financial Markets Test 1 — Questions and Answers
Question 1: The various types of markets where derivatives are traded include
- Cash flow backed markets
- Mortgage backed markets
- Derivative securities markets (Correct answer)
- Assets backed market
Correct answer: Derivative securities markets
Derivative securities markets are specialized financial markets where derivative contracts, such as futures, options, and swaps, are traded. These markets are distinct from cash markets, where the underlying assets themselves are bought and sold. Derivatives derive their value from an underlying asset, index, or rate.
Question 2: When purchasing a put option, the likelihood that the buyer will experience a loss rises as
- Falling stock price
- Lengthening of the maturity period
- A shorter maturity period
- A rise in the stock price (Correct answer)
Correct answer: A rise in the stock price
When purchasing a put option, the buyer profits if the underlying stock price falls below the strike price. Therefore, if the stock price rises, the put option becomes less valuable, potentially expiring worthless. A continuous rise in the stock price directly increases the likelihood that the put option buyer will experience a loss.
Question 3: To determine ____, the cost of an option is deducted from its time value.
- Market index
- Intrinsic value (Correct answer)
- Extrinsic value
- Book value index
Correct answer: Intrinsic value
An option's total premium (cost) is composed of two main parts: its intrinsic value and its time value (also known as extrinsic value). The intrinsic value represents the immediate profit if the option were exercised. Therefore, if you subtract the time value from the total option cost, the remaining amount is the intrinsic value of the option.
Question 4: The kind of swaps in which two counterparties trade fixed interest payments for floating payments
- Interest rate swaps (Correct answer)
- Indexed swaps
- Counter party swaps
- Float-fixed swaps
Correct answer: Interest rate swaps
Interest rate swaps are financial contracts where two parties agree to exchange future interest payments. Specifically, one counterparty typically pays a fixed interest rate while receiving a floating interest rate payment from the other. This mechanism allows companies to manage their exposure to interest rate fluctuations or to convert existing debt from fixed to floating rates, or vice versa.
Question 5: When a significant amount of the proceeds are borrowed from the investor's broker, the situation is referred as as
- Forward investment
- Leverage investment (Correct answer)
- Non-leveraged investment
- Future investment
Correct answer: Leverage investment
Leverage investment refers to the strategy of using borrowed capital to increase the potential return of an investment. When an investor borrows a significant portion of the funds from their broker to make an investment, they are employing leverage. While leverage can amplify gains, it also significantly increases the risk of losses, as the investor is still responsible for repaying the borrowed amount plus interest.
Question 6: It is categorized as a future asset exchange contract when it involves a fixed price.
- Present contracts
- Spot contract
- Forward contract (Correct answer)
- Future contracts
Correct answer: Forward contract
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date. Unlike standardized futures contracts, forward contracts are privately negotiated and tailored to the specific needs of the counterparties. This allows for flexibility in terms of asset, quantity, and delivery date, but also carries counterparty risk.
Question 7: To calculate _____, the capital gain is subtracted from the return to investors.
- Constant spot rate payment
- Constant forward rate payment
- Constant future rate payment
- Periodic dividend payments (Correct answer)
Correct answer: Periodic dividend payments
Periodic dividend payments are the distributions of a company's earnings to its shareholders, typically made on a regular schedule. To calculate these payments when given the total return to investors and the capital gain, you subtract the capital gain from the total return. This is because the total return on an investment is comprised of both capital gains (from price appreciation) and income (such as dividends).
Stock Institutions and Financial Markets Test 1
The various types of markets where derivatives are traded include