Chapter 2

Question 1

What is a forward contract?

Answer 1

An agreement between two parties to trade an asset at a certain future time for a certain price.

Question 2

In which market are forward contracts typically traded?

Answer 2

Over-the-counter market (OTC).

Question 3

What is the role of a Central Clearing Party (CCP) in forward contracts?

Answer 3

It collects margin payments from both parties similar to a standardized futures contract.

Question 4

What positions do the parties assume in a forward contract?

Answer 4

• Long position: party that buys the underlying asset
• Short position: party that sells the asset.

Question 5

How can forward contracts be used in foreign exchange?

Answer 5

They can hedge foreign currency risk.

Question 6

What is an example of using a forward contract to hedge currency risk?

Answer 6

A UK company entering a long forward contract to buy dollars to pay a US supplier.

Question 7

What determines the rates for forward currency deals?

Answer 7

Spot rates adjusted for the difference in interest rates between the two currencies.

Question 8

What are the costs associated with using forward contracts?

Answer 8

• Removal of appreciation possibility of foreign currency
• Bid/offer spread is typically larger than spot transactions.

Question 9

What is the payoff from a long position in a forward contract?

Answer 9

S_T - K.

Question 10

What is the payoff from a short position in a forward contract?

Answer 10

K - S_T.

Question 11

What does the forward price K represent?

Answer 11

The delivery price, usually set so that the contract value at time 0 is zero.

Question 12

What is a key difference between forward contracts and futures contracts?

Answer 12

Futures contracts are normally traded on an exchange.

Question 13

What are the standard features specified by the exchange in a financial futures contract?

Answer 13

Details such as contract size, expiration dates, and delivery mechanisms.

Question 14

How is the delivery date specified in futures contracts?

Answer 14

By the month of delivery, with the exchange specifying the delivery period.

Question 15

What is the nature of options in derivatives?

Answer 15

Options are contracts that provide the right, but not the obligation, to buy or sell an asset.

Question 16

Where are options typically traded?

Answer 16

• Exchanges
• Over-the-counter market.

Question 17

What is the primary negotiation point in traded options?

Answer 17

The premium for the contract.

Question 18

What distinguishes OTC derivatives from exchange-traded derivatives?

Answer 18

OTC derivatives are not traded on a recognized exchange.

Question 19

What is the payoff structure for options?

Answer 19

Varies based on whether it is a call or put option and the relationship between the strike price and the market price.

Question 20

Fill in the blank: The holder of a forward contract is obligated to buy the asset at price K even if the market price is _______.

Answer 20

less than K.

Question 21

True or False: The forward price is also known as the delivery price.

Answer 21

True.

Question 22

What is an over-the-counter (OTC) derivative?

Answer 22

A derivative that is not traded on a recognised exchange.

Question 23

What types of options are there?

Answer 23

• Call option: right to buy the underlying asset
• Put option: right to sell the underlying asset

Question 24

What does a call option give to the holder?

Answer 24

The right to buy the underlying asset by a certain date for a certain price.

Question 25

What does a put option give to the holder?

Answer 25

The right to sell the underlying asset by a certain date for a certain price.

Question 26

What is the difference between American and European options?

Answer 26

* American options: can be exercised any time up to the expiration date * European options: can only be exercised on the expiration date

Question 27

What is the strike price in options trading?

Answer 27

The agreed price in the contract at which the underlying asset can be bought or sold.

Question 28

What is an option premium?

Answer 28

The price paid by the buyer of the option to the writer for the choice to trade.

Question 29

What is the payoff for a call option if the share price is less than the strike price?

Answer 29

The investor will not exercise the option and loses the premium paid.

Question 30

What is the formula for the payoff of a call option when exercised?

Answer 30

Payoff = Sr - K - 0

Question 31

What happens if the stock price Sr is greater than the strike price K for a call option?

Answer 31

The holder should buy the share at the strike price and can sell it at the market price, making a profit.

Question 32

What is the payoff for an investor who sells a call option?

Answer 32

Payoff = 0 - Sr + K

Question 33

What is the payoff for a long position in a put option?

Answer 33

Payoff = K - Sr - 0

Question 34

What is the payoff for an investor who writes a put option?

Answer 34

Payoff = 0 - K + Sr

Question 35

How do the payoffs for put options differ based on the stock price relative to the strike price?

Answer 35

* If Sr > K: Payoff = -0 * If Sr < K: Payoff = K - Sr - 0

Question 36

What is a straddle in options trading?

Answer 36

A speculative strategy where both put and call options are purchased simultaneously with the same strike price and date.

Question 37

What is the terminal value of payoff for European options?

Answer 37

The payoff at maturity, excluding the initial outlay or option price.

Question 38

What is the formula for the payoff of a put option if exercised?

Answer 38

Payoff = max(K - Sr, 0)

Question 39

What is the impact of the option premium on the payoff diagrams?

Answer 39

Payoff diagrams exclude the option premium.

Question 40

What is the payoff for a long call option?

Answer 40

max(Sr - K, 0) ## Footnote Sr is the underlying asset price at maturity and K is the strike price.

Question 41

What is the payoff for a short call option?

Answer 41

min(K - Sr, 0) ## Footnote This represents the loss when the short position in a call option is exercised.

Question 42

What is the payoff for a long put option?

Answer 42

max(K - Sr, 0) ## Footnote This indicates the profit from exercising a put option when the underlying asset price is below the strike price.

Question 43

What is the payoff for a short put option?

Answer 43

min(Sr - K, 0) ## Footnote This represents the loss when the short position in a put option is exercised.

Question 44

What do payoff diagrams typically ignore?

Answer 44

* Taxes * Transaction costs * Income from the underlying asset * Margin payments * Discounting of premium payments ## Footnote Payoff diagrams focus solely on the relationship between asset value at maturity and the strike price.

Question 45

What is a forward contract?

Answer 45

A non-standardized contract between two parties to trade a specified asset on a set date in the future at a specified price.

Question 46

What is the payoff from a long position in a forward contract?

Answer 46

Sr - K ## Footnote Sr is the asset price at maturity and K is the agreed price in the forward contract.

Question 47

What is the payoff from a short position in a forward contract?

Answer 47

K - Sr ## Footnote This is the opposite of the payoff for a long position.

Question 48

What is the difference between futures and forwards?

Answer 48

* Futures are standardized and traded on exchanges * Forwards are non-standardized and typically traded over-the-counter (OTC) * Futures have lower counterparty credit risk due to margin requirements * Forwards can involve more negotiation and counterparty credit risk

Question 49

What determines the agreed delivery price in a forward contract?

Answer 49

* Current share price * Current risk-free rate * Expected dividends * Term to maturity

Question 50

What is the total combined profit of the purchaser and the writer of an option?

Answer 50

Zero ## Footnote The gain for one party equals the loss for the other party.

Question 51

When will a long call option be exercised?

Answer 51

If Sr > K ## Footnote The holder profits by exercising the option when the asset price exceeds the strike price.

Question 52

What happens if a long put option is exercised?

Answer 52

If Sr < K, the holder will receive K for an asset worth Sr, resulting in a profit of K - Sr - 0.

Question 53

What is a straddle?

Answer 53

A strategy involving both a call and a put option with the same strike price and expiration date.

Question 54

When does a straddle generate a profit?

Answer 54

If either: * Sr < K - 2P * Sr > K + 2P ## Footnote P is the premium paid for each option.

Question 55

What is the payoff from a call option when Sr < K?

Answer 55

-0 ## Footnote The option expires worthless, and the loss is the premium paid.

Question 56

What is the impact of margin payments in forward contracts?

Answer 56

If centrally cleared, margin payments are generally required, reducing counterparty credit risk.

Question 57

What is the key difference in liquidity between futures and forwards?

Answer 57

Futures are highly marketable and liquid, while forwards are often illiquid and difficult to close out.