TRUE FALSE QUESTIONS

Indicate whether the following statements are ‘True’ or ‘False’. Support your answer with reasons.
1. A hedger seeks to get riskless profit from market inefficiencies.
False. A hedger seeks to protect a position or anticipated position in the spot
market by using an opposite position in other assets. On the other hand, An
arbitrage transaction involves buying the assets at the lower price and selling it at
a higher price. Arbitrageurs seek to get benefits from market
inefficiencies/imperfections.

2. Time value of option is the present value of exercise price.

False. The difference between market price and intrinsic value is called time
value or time premium or speculative value.
Time value = Market price − Intrinsic value

3. An overpriced or underpriced call in binomial model gives arbitrage

opportunities.
True. If the call were overpriced, there is an arbitrage opportunity and a riskless
hedge could generate a riskless return in excess of the risk-free rate. In this case,
overpriced call should be sold and stock should be short sold. On the other hand,
if the call option is underpriced, the call should be purchased and stock should be
short sold.

4. The stock price volatility is directly related with both call prices and put prices.
True. Other things being equal, options with volatile stock prices (returns) will be
more valuable than with stock with stable prices (returns). The higher volatility
increases the probability that a significant change will occur in the stock’s price.
Higher volatility in stock price increases value of both call and put options.
Therefore, there is direct relationship with call and put prices with stock price
volatility.

5. Put delta measures the change in put price due to small change in stock price.
True. Put delta (∆) = N (d1) −1. Put option deltas always range from -1 to 0 because as
the underlying security increases, the value of put options decrease. For example, if a put
option has a delta of -0.33, if the price of the underlying asset increases by $1, the price
of the put option will decrease by $0.33. Technically, the value of the option's delta is
the first derivative of the value of the option with respect to the underlying security's
price.

6. In future market, gain and losses are incurred at the end of contract’s life when
delivery is made.
2 FINANCIAL DERIVATIVES

False. Future contracts are ‘marked to market’ on a daily basis, meaning that
gains and losses are noted and money must be put up to cover losses.

7. Currency swap involves payment of interest in same currency and principal in

different currencies.
False. A currency swap is a contract between two parties to exchange series of
cash flows in different currencies. Either or both sets of payments can be fixed or
floating. A currency swap agreement requires the principal to be specified in each
of the two currencies. The principal amounts are usually exchanged at the
beginning and at the end of the life of the swap. Usually the principal amounts
are chosen to be equivalent using the exchange rate at the swaps initiation.
Because the payments in a currency swap are in different currencies, they are
typically not netted. Currency swaps are generally used to hedge against risk of
fluctuation in currency exchange rate.

8. Basis is the difference between future price and cash price.

True. Basis is the variation between the spot price of a deliverable commodity
and the relative price of the futures contract for the same actual that has the
shortest duration until maturity.

9. Risk management is the primary reason that the derivatives markets exist.
True.
Derivative securities can be used in a manner that will generate gains if the value
of the underlying assets declines. Consequently, financial institutions and other
firms can use derivative securities to adjust the risk of their existing investments
in securities. If a firm maintains investments in bonds, for example, it can take
specific positions in derivative securities that will generate gains if bond values
decline. In this way, derivative securities can be used to reduce a firm’s risk. The
loss on the bonds is offset by the gains on these derivative securities.

10. An increase in interest rates affects the value of put and call options differently.
True.
The interest rate is used to calculate the present value of the striking price. Higher
interest rate reduce the present value of the striking price and increase the
option’s value. Therefore, higher interest rate lowers the present value of exercise
price, and increases the value of call option but value of put option decrease.
Thus, increase in interest rate affects value of put and call options differently.
 I N T ROD U CT I ON Chapter 1 3

11. Margins are important aspects of forward markets because an investor keeps a
margin account with his/her broker.
False.
Margins are important aspects of futures markets because an investor keeps a
margin account with his/her broker. At purchase or short sold, investor must put
margin at brokerage account.

12. A plain vanilla interest rate swap is equivalent to issuing a fixed-rate bond and
using the proceeds to buy a floating-rate bond or vice versa.
True. In plain vanilla interest rate swaps, one party pays a fixed rate and other
party pays a floating rate bond such as LIBOR.

13. Other things holding constant, a longer-lived option most have a value greater
than or equal to the value of option with short life.
False. A call with longer maturity has a value greater than the value of similar
call with shorter maturity. In normal condition, longer-lived call is worth more,
but if it carries no time value when the shorter-lived option expires, two options
will have the same price. This can also occur if both options have some remaining
life. A longer-lived put has a value greater than the value of similar put with
shorter life.

14. An option can be prices at less than zero because it can potentially
generate a large profit for its owner.
False. The price or value of the option cannot be negative, thus its minimum
value will be zero.

15. Buying a call is bullish strategy whereas selling a put is a bearish strategy.
True. An investor who is very bullish on a particular stock and wants to profit
from a rise in its price will buy call. Buying a call is one of the simplest and most
popular strategies used by option investors. It allows an investor the opportunity
to profit from an upward move in the price of the underlying stock. On the other
selling a put also bullish strategy. Selling puts is a bullish strategy, much like the
long call strategy.

16. Investors can buy put options to manage downside risks and write call option to
manage upside risks.
False. Investors use buy put or write call to manage downside risk. Buy put or
write call is combine with stock purchase.
4 FINANCIAL DERIVATIVES

17. Minimum value of option and speculative value of option are same for American
option if option is in-the-money.
False.
The minimum value of American option is zero. The price of an American call
normally exceeds its intrinsic value. The difference between the price and the intrinsic
value is called the time value or speculative value of the call.

18. Swaps are the standardized contract because they are traded in organized
exchange.
False. Swaps are not traded in any organized secondary market. Swaps are over-
the-counter market instruments. Thus, the two parties are usually a dealer which
is financial institution that makes market in swap (a swap dealer), and an end
user, which is usually a customer of the dealer and might be a corporation,
pension fund, hedged fund, or some other organizations or other swap dealers.

19. A derivatives transaction involves actual transfer of ownership of the underlying

asset at the time the contract is initiated.
False. Derivative transaction is not actual transfer of ownership of the underlying
assets. Some of the contract may be deliverable at the maturity period.

20. A daily settlement procedure of futures contract minimizes the

counterparties' default risk in future contract.
True. Future contracts are ‘marked to market’ on a daily basis, meaning that gains and
losses are noted and money must be put up to cover losses.

21. Contango is the condition when the futures price is above the expected future
spot price.
True. Contango is a situation where the futures price of a commodity is above the
expected future spot price. Contango refers to a situation where the future spot price is
below the current price, and people are willing to pay more for a commodity at some
point in the future than the actual expected price of the commodity. This may be due
to people's desire to pay a premium to have the commodity in the future rather than
paying the costs of storage and the carry costs of buying the commodity today.

22. Buying put option is economically equivalent to writing a call option.

False. Both strategy are bearish strategy but not economically equivalent.

23. Value of forward contract at the time of contract is always zero.

True. Value of forward contract at the time of contract is always zero. Forward
 I N T ROD U CT I ON Chapter 1 5

contracts are buy/sell agreements that specify the exchange of a specific asset
and on a specific future date but on a price that is agreed upon today. They do
not require early payment or down payment unlike some other future
commitment derivative instruments. Since no money changes hands at the
initial agreement, no value can be attributed to it. In other words, the forward
price is equal to the delivery price.

24. In plain vanilla interest rate swap, both sets of interest payments can be at fixed
rate or at floating rate.
False. In Plain vanilla interest rate swap, interest rate can be set as fixed versus
floating.

25. A person who buys a put option has an obligation to sell if the option writer
exercises.
Fasle. Buyer of put option has right to sell the underlying asset to the seller. and
put seller has obligations.

26. A major difference between a currency swap and an interest rate swap is that
notional principal is exchanged in an interest rate swap while it is not in the
currency swap.
False. Notional principal is not exchange in interest rate swap and it is exchanged
in currency swap.

27. Any call with a greater time to maturity is always valued at a higher price than a
call with shorter time to maturity.
True. Other things being equal, options with longer lives have higher values because
of the greater probability that a significant change will occur in the stock’s price.
Moreover, the greater the time to option expiration, the lower the present value of the
exercise price to be paid in the future, which also increases the value of the call and
put option.

28. Arbitrage is a transaction designed to capture profits resulting from market

efficiency.
6 FINANCIAL DERIVATIVES

False. Arbitrage involves looking in a risk-less profit by simultaneously engaging into

transactions in two or more markets. An arbitrage transaction involves buying the
assets at the lower price and selling it at a higher price. Arbitrageurs seek to get
benefits from market inefficiencies/imperfections. If prices are not in equilibrium,
there are arbitrage opportunities.

29. Possible profit of a put option buyer is unlimited.

False. Possible profit of a put option buyer is limited if stock price decreases to
zero.

30. Futures trading is centralized trading that the futures exchange controls the terms
of trading.
True. Future trading is centralized, regulated trading with rules and regulations
set by government of the country.

31. A riskless hedge involving stock and puts requires a long position in stock and a
short position in puts.
False. Riskless hedge involving the long position stock and put.

32. Derivative market is a zero sum game.

Zero sum game is the game in which one party’s gain is exactly equal with the loss of
other party. Financial derivatives are the zero sum game as one party makes the profit
in the expense of other. Neither both parties can gain nor have to bear loss
simultaneously. The gain of buyer is equal to the loss of seller. Therefore, the payoff or
profit from a derivative for buyer and seller are oppositely related. If payoffs of both
are summed up, the result is always zero. Therefore, derivatives are also called zero-
sum game. It can also be seen from above example. When the gain for Ram is Rs
10,000 and the loss for the Shyam is Rs 10,000. If we add these values then value will
be zero.

33. Derivative instruments are tools to manage the risk but those instruments in
isolation are very risky in nature.
True. Individual derivative instrument is very risky. But it can be used to manage
or reduce risk with other alternatives.

34. Protective put is profitable during the bull market where as cover call is
profitable during the bear market.
False. Both strategy provides the profit in bull market. and protected from loss
from the bear market.
 I N T ROD U CT I ON Chapter 1 7

35. The futures traders may withdraw from margin account the amount
above the maintenance margin without closing the position.
False. Futures traders may withdraw from the account is margin is over
margined. In case of between initital margin and maintenance margin, traders
cannot withdraw.

36. Writing the put is riskier than writing the call.

False. Writing call is more risky because loss is unlimited. On the other hand,
writing put is less risky because loss is limited.

37. Selling a put is a bullish strategy that has limited profit but unlimited loss.
False. Selling puts is a bullish strategy, much like the long call strategy with
limited loss and gain.

38. Party paying equity return on equity swap knows the return to be paid at the
beginning of settlement period.
False. Equity return is not know at beginning because stock price changes over
the periods.

39. During the period of high interest rate, price of call option tends to be lower.
False. The risk free rate is used to calculate the present value of the striking price.
Higher risk free rate reduce the present value of the striking price and increase
the option’s value. Therefore, higher risk free rate lowers the present value of
exercise price, and increases the value of call option.

40. A bearish investor buys call option.

False. An investor who is very bullish on a particular stock and wants to profit
from a rise in its price will buy call. Buying a call is one of the simplest and most
popular strategies used by option investors. It allows an investor the opportunity
to profit from an upward move in the price of the underlying stock.

41. A forward contract is custom-tailored contract.

True. A forward contract is a private transaction. There is no regulatory agency for
forward contract. Term and conditions are fixed by the two parties. Counterparties
can determine and define the terms and features to fit their specific needs, including
when delivery will take place and the exact identity of the underlying asset.
Primary advantage of forward contracts is that they are unregulated, over the counter
market transactions. Forwards are very flexible and normally no commissions are
8 FINANCIAL DERIVATIVES

paid on the trade. Forward contracts have three major disadvantages. Forward
contracts are illiquid. They have credit risk and they are unregulated.

42. The swap market is an unregulated market.

True. Swaps are largely unregulated. Swaps are basically unregulated. Due to
unregulated contract there is chance of manipulation by counterparties.

43. Buying a call option is a bullish strategy.

True. An investor who is very bullish on a particular stock and wants to profit
from a rise in its price will buy call. Buying a call is one of the simplest and most
popular strategies used by option investors. It allows an investor the opportunity
to profit from an upward move in the price of the underlying stock.

44. Futures contracts have less credit risk because they follow daily settlement
procedure.
False. There is less credit and default risk in future contracts because the
exchanges, clearing house guarantees all payments of profits.

45. Interest rate swaps are used to manage the risk due to fluctuation in market
interest rates.
True. Interest rate swap is used to minimize the market interest rates.

46. Maximum value of put is exercise price.

False. The maximum value of a European put is the present value of the exercise price.
The maximum value of an American put is the exercise price.

47. Plain Vanilla swaps are usually used by banks to hedge the value of their foreign
currency holding from change in exchange rate.
False. Plain Vanilla swaps are usually used by banks to hedge the interest rate
risk.

48. Derivatives are financial instrument issued by firm.

False. Derivatives are the financial contract created by contract between two
parties.

49. Strike price of an option refers to the price paid to the option.
Fasle. Strike price is the contract or exercise price at which the underlying assets
can be purchase or sold at future date.
 I N T ROD U CT I ON Chapter 1 9

50. Call with higher exercise price has higher call price.
Fasle. Other things being equal, a higher striking price reduces the call option
value because the higher the striking price, the lower the probability the call will
be exercised.

51. If a call option in binomial model is overpriced, there is arbitrage opportunity.

True. If the call were overpriced, there is an arbitrage opportunity and a riskless
hedge could generate a riskless return in excess of the risk-free rate. In this case,
overpriced call should be sold and stock should be short sold. On the other hand,
if the call option is underpriced, the call should be purchased and stock should be
short sold.

52. Speculator who takes position in financial derivatives is to minimize the loss.
False. Speculator takes higher risk in search of higher profit in future. Speculators bet
on the future direction of a market variable. Only good forecaster can get profit from
speculation. Knowledge of timing and direction of the movement in market variables
is important for speculating strategy. Speculator can benefit from both up and down
trend of market.

53. In a basis swap, one counterparty pays fixed rate and another counterparty pays
floating interest rate.
False. In a basis swap, both party pays floating interest rate.

54. Arbitrageurs attempt to take advantage of a discrepancy between prices of

same asset in two different markets.
True. Arbitrageurs take advantage from the price difference from two market by
buying at low and selling at high.

55. Writing covered call is less risky than writing a naked or uncovered call.
True. A covered call is an option strategy you can use to reduce risk on your long
position in an asset by writing call options on the same asset. Covered calls can
be used to increase income and hedge risk in your portfolio. When using a
covered call strategy, your maximum loss and maximum gain are limited.
An investor who sells a naked call or uncovered call believes that the underlying
stock price will fall and that they will be able to profit from a decline in the stock
price by selling calls. An investor who sells a call is obligated to deliver the
underlying stock if the buyer decides to exercise the option. When looking to
establish a position, the seller’s maximum gain is premium received and
maximum loss is unlimited. Therefore, the a naked or uncovered call is more
10 FINANCIAL DERIVATIVES

risky than covered call.

56. The options are zero sum game.

Zero sum game is the game in which one party’s gain is exactly equal with the
loss of other party. Option are the zero sum game as one party makes the profit in
the expense of other. Neither both parties can gain nor have to bear loss
simultaneously. The gain of buyer is equal to the loss of seller. Therefore, the
payoff or profit from a option for buyer and seller are oppositely related. If
payoffs of both are summed up, the result is always zero. Therefore, options are
also called zero-sum game.

57. To determine the value of swap is to determine the fixed rate of payments to
make by one of the counterparties.
False. The value of the swap is the difference between the present values of two
streams of payments.

58. The increase in the stock price decreases the value of the call option on the stock.
False. Current stock price is one of the most important determinants of the price
of a stock option. As other things being equal, higher stock price result in higher
call option price.

59. The swaps can be analyzed as the portfolio of forward contract with a series of
payments.
False. The major difference between these two derivatives is that swaps result in
a number of payments in the future, whereas the forward contract will result in
one future payment.

60. The gains or losses of the forward contracts are settled daily.
False. Forward contracts are based on future time means the delivery of assets
will be in future, so gain or loss realize at the maturity date.

61. A European option may be exercised anytime up to and including expiration

date.
False. A European option is an option that can only be exercised at the end of its
life, at its maturity.

62. The higher the exercise price is, the less the call is worth, everything else being
equal.
False. Other things being equal, a higher striking price reduces the call option
 I N T ROD U CT I ON Chapter 1 11

value because the higher the striking price, the lower the probability the call will
be exercised.

63. Values of derivative securities are determined by the movement of

market price of underlying assets.
True. Value of financial derivatives depends on the value of other assets. The
other assets is called underlying assets. Value of financial derivatives becomes
increases or decreases depending upon the price of underlying asset or market
price of underlying assets. Example of underlying assets includes financial assets
and commodities etc.

64. Futures contracts are generally standardized instruments that are traded on
exchanges.
True. Future contracts are standardized in terms of quantity, expiration date,
settlement procedures etc. only the price is negotiated. Trading Futures are
traded on organized exchange.

65. An option is the right to either purchase or sell something at a fixed price in the
future, but has no obligation.
False. Option is a contract between two parties in which one party has the right
but not the obligation to do something, usually to buy or sell some underlying
asset. Having rights without obligations has financial value, so option holders
must purchase these rights, making them assets. This asset derives their value
from some other asset, so they are called derivative assets. The cost of an option
is termed the premium. There are two parties involved in the option contract.
They are option buyer and option seller.

66. An interest rate swap is a swap in which the two parties agree to exchange a
series of interest payments in the different currency to each other.
False. A swap in which the two parties agree to exchange a series of interest
payments in same currency.

67. Put option on stocks protect against losses from a decline in stock prices.
True. Put option on stocks can be used to hedge against the downside risk. This
composition is known as protective put. Protective put is an option strategy in
which an investor purchases a put option to guard against any loss on the
underlying asset which he already owns. Protective put is like insurance against
loss on the underlying asset. If event is occurred and property is lost, insurance
company gives compensation for the loss; otherwise the premium paid is
12 FINANCIAL DERIVATIVES

expenses to us. Similarly, the premium paid for buying put option is the
insurance premium for getting compensation of loss in bear market. If market
price of underlying asset decreased significantly, the investor bears loss from it.

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