CFA Level 1 - Derivative Investments Session 17 - Reading 60 (Notes, Practice Questions, Sample Questions) 1. Which of the following statements regarding exchange-traded derivatives is NOT correct? Exchange-traded derivatives: A)often trade in a physical location. B)are illiquid. C)are standardized contracts Explanation: B — Derivatives that trade on exchanges havegood liquidity in most cases. They have the other characteristicslisted 2. A derivative security: A)is like a callable bond.B)has a value dependent on the shape of the yield curve. C)is one that is based on the value of another security Explanation: C — A derivative security is one that ‘derives’ itsvalue from that of another security 3. A ﬁnancial instrument that has payo s based on the price of an underlying physical or ﬁnancial asset is a(n): A)option. B)derivative security. C)future
Explanation: B — Options and futures are examples of types ofderivative securities 4. A derivative security: A)has no default risk.B)has a value based on stock prices. C)has a value based on another security or index Explanation: C — This is the deﬁnition of a derivative security.Those based on stock prices are equity derivatives 5. Which of the following is most likely an exchange-traded derivative? A)Equity index futures contract. B)Bond option.C)Currency forward contract Explanation: A — Futures are exchange-traded derivatives.Forward contracts and swaps are over-the-counter derivatives.Bond options are traded almost entirely in theover-the-counter market 6. Which of the following is NOT an over-the-counter (OTC) derivative? A)A futures contract. B)A forward contract.C)A bond option
Explanation: A — Futures contracts are exchange-traded;forwards and most bond options are OTC derivatives 7. Over-the- counter derivatives: A)have good liquidity in the over-the-counter (OTC) market.B)are backed by the OTC Clearinghouse. C)are customized contracts. Explanation: C — OTC derivative contracts (securities) arecustomized and have poor liquidity. The contract is with aspeciﬁc counterparty and there is default risk since there is noclearinghouse to guarantee performance 8. Which of the following is most accurate regarding derivatives? A)Exchange-traded derivatives are created and traded by dealersin a market with no central location. B)Derivative values are based on the value of another security,index, or rate. C)Derivatives have no default risk Explanation: B — Derivatives “derive” their value from thevalue or return of another asset or security. Exchange-tradedderivatives are standardized and backed by a clearinghouse. Anover-the-counter derivative, such as a forward contract or aswap, exposes the derivative holder to the risk that thecounterparty may default
9. Derivatives are often criticized by investors with limited knowledge of complex ﬁnancial securities. A common criticismof derivatives is that they: A)increase investor transactions costs. B)can be likened to gambling. C)shift risk among market participants Explanation: B — Derivatives are often likened to gambling dueto the high leverage involved in the payo s. One of the beneﬁtsof derivatives is that they reduce transactions costs. Anotherbeneﬁt of derivatives is that they allow risk to be managed andshifted among market participants 10. MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period. The consensusexpectation of ﬁnancial analysts had been an increase in EPS of10%. After the earnings announcement the value of MBTcommon stock increased each day for the next ﬁve trading days,as analysts and investors gradually reacted to the better thanexpected news. This gradual change in the value of the stock is anexample of: A)speculation.B)e cient markets. C)ine cient markets Explanation: C — A critical element of e cient markets is thatasset prices respond immediately to any new information thatwill a ect their value. Large numbers of traders responding insimilar fashion to the new information will create a temporaryimbalance in supply and demand, and this will adjust assetmarket values
11. Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT: A)engage in high risk speculation.B)increase market e ciency through the use of arbitrage. C)narrow the amount of trading opportunities to a moremanageable range Explanation: C — Financial derivatives increase theopportunities to either speculate or hedge on the value ofunderlying assets. This adds to market completeness byincreasing the range of identiﬁable payo s that can be used bytraders to fulﬁll their needs. Financial derivatives such asmarket index futures can also be easier and cheaper thantrading in a diversiﬁed portfolio, thereby adding to theopportunities available to traders 12. Which of the following statements about arbitrage is NOT correct A)Arbitrage can cause markets to be less e cient. B)No investment is required when engaging in arbitrage.C)If an arbitrage opportunity exists, making a proﬁt without riskis possible Explanation: A — Arbitrage is deﬁned as the existence ofriskless proﬁt without investment and involves selling an assetand simultaneously buying the same asset for a lower price.Since the trades cancel each other, no investment is required.Because it is done simultaneously, a proﬁt is guaranteed,making the transaction risk free. Arbitrage actually helps make
markets more e cient because price discrepancies areimmediately eradicated by the actions of arbitrageurs 13. Which of the following is a common criticism of derivatives? A)Derivatives are likened to gambling. B)Derivatives are too illiquid.C)Fees for derivatives transactions are relatively high Explanation: A — Derivatives are often likened to gambling bythose unfamiliar with the beneﬁts of options markets and howderivatives are used 14. All of the following are beneﬁts of derivatives markets EXCEPT: A)transactions costs are usually smaller in derivatives markets,than for similar trades in the underlying asset. B)derivatives markets help keep interest rates down. C)derivatives allow the shifting of risk to those who can moste ciently bear it Explanation: B — The existence of derivatives markets does nota ect the level of interest rates. The other statements are true 15. One reason that criticism has been leveled at derivatives and derivatives markets is that: A)derivatives have too much default risk.B)derivatives expire. C)they are complex instruments and sometimes hard tounderstand
Explanation: C — The fact that derivative securities aresometimes complex and often hard for non-ﬁnancialcommentators to understand has led to criticism of derivativesand derivative markets 16. Which of the following relationships between arbitrage and market e ciency is least accurate? A)The concept of rationally priced ﬁnancial instrumentspreventing arbitrage opportunities is the basis behind theno-arbitrage principle. B)Market e ciency refers to the low cost of trading derivativesbecause of the lower expense to traders. C)Investors acting on arbitrage opportunities help keep marketse cient Explanation: B — Market e ciency is achieved when allrelevant information is reﬂected in asset prices, and does notrefer to the cost of trading. One necessary criterion for markete ciency is rapid adjustment of market values to newinformation. Arbitrage, trading on a price di erence betweenidentical assets, causes changes in demand for and supply of theassets that tends to eliminate the pricing di erence 17. Which of the following is least likely one of the conditions that must be met for a trade to be considered an arbitrage? A)There are no commissions. B)There is no risk.C)There is no initial investment.
Explanation: A — In order to be considered arbitrage there mustbe no risk in the trade.It doesn’t matter if commissions are paid as long as the amountof the price discrepancy is enough to o set the amount paid incommissions.In order to be considered arbitrage there must be no initialinvestment of one’s own capital. One must ﬁnance any cashoutlay through borrowing 18. Any rational quoted price for a ﬁnancial instrument should: A)provide no opportunity for arbitrage. B)provide an opportunity for investors to make a proﬁt.C)be low enough for most investors to a ord. Explanation: A — Since any observed pricing errors will beinstantaneously corrected by the ﬁrst person to observe them,any quoted price must be free of all known errors.This is the basis behind the text’s no-arbitrage principle, whichstates that any rational price for a ﬁnancial instrument mustexclude arbitrage opportunities.The no-arbitrage opportunity assumption is the basicrequirement for rational prices in the ﬁnancial markets.This means that markets and prices are e cient.That is, all relevant information is impounded in the asset’sprice.With arbitrage and e cient markets, you can create the optionand futures pricing models presented in the text 19. Which of the following is the best interpretation of the no-arbitrage principle?
A)There is no way you can ﬁnd an opportunity to make a proﬁt.B)The information ﬂow is quick in the ﬁnancial market. C)There is no free money. Explanation: C — An arbitrage opportunity is the chance tomake a riskless proﬁt with no investment.In essence, ﬁnding an arbitrage opportunity is like ﬁnding freemoney.As you recall, in arbitrage, you observe two identical assets withdi erent prices.Your immediate response should be to buy the cheaper one andsell the expensive one short.You can then deliver the cheap one to cover your short position.Once you take the initial arbitrage position, your arbitrage proﬁtis locked in.The no-investment statement referenced in the text refers tothe assumption that when you short the expensive asset, youwill be given access to the cash created by the short sale.With this cash, you now have the money to buy the cheaperasset.The no-investment assumption means that the ﬁrst person toobserve a market pricing error will have the ﬁnancial resourcesto correct the pricing error instantaneously all by themselves 20. The process that ensures that two securities positions with identical future payo s, regardless of future events, will have thesame price is called: A)arbitrage. B)exchange parity.C)the law of one price
Explanation: A — If two securities have identical payo sregardless of events, the process of arbitrage will move pricestoward equality. Arbitrageurs will buy the lower priced positionand sell the higher priced position, for an immediate proﬁtwithout any future liability. The law of one price (for securitieswith identical payo s) is not a process; it is ‘enforced’ byarbitrage 21. Which of the following is an example of an arbitrage opportunity? A)A put option on a share of stock has the same price as a calloption on an identical share. B)A portfolio of two securities that will produce a certain returnthat is greater than the risk-free rate of interest. C)A stock with the same price as another has a higher rate ofreturn Explanation: B — An arbitrage opportunity exists when acombination of two securities will produce a certain payo inthe future that produces a return that is greater than therisk-free rate of interest. Borrowing at the riskless rate topurchase the position will produce a certain future amountgreater than the amount required to repay the loan 22. The process of arbitrage does all of the following EXCEPT: A)promote pricing e ciency.B)produce riskless proﬁts. C)insure that risk-adjusted expected returns are equal Explanation: C — Arbitrage does not insure that therisk-adjusted expected returns to two risky assets will be equal.
Arbitrage is based on risk-free portfolios and promotes e cientpricing of assets. When an arbitrage opportunity is presented bya mispricing of assets, the increased supply of the ‘overpriced’asset and the increased demand for the ‘underpriced’ asset byarbitrageurs, will move the prices toward equality and act tocorrect the mispricing 23. A standardized and exchange-traded agreement to buy or sell a particular asset on a speciﬁc date is best described as a: A)forward contract. B)futures contract. C)swap Explanation: B — Futures contracts are standardized forwardcontracts that trade on organized exchanges. Other types offorward contracts, as well as swaps, are custom instrumentsthat are generally not exchange-traded