CFA Level 1 - Derivative Investments Session 17 - Reading 60

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 have good liquidity in most cases. They have the other characteristics listed 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’ its value from that of another security 3. A financial instrument that has payoffs 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 of derivative 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 the over-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) are customized and have poor liquidity. The contract is with a specific counterparty and there is default risk since there is no clearinghouse to guarantee performance 8. Which of the following is most accurate regarding derivatives? A)Exchange-traded derivatives are created and traded by dealers in 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 the value or return of another asset or security. Exchange-traded derivatives are standardized and backed by a clearinghouse. An over-the-counter derivative, such as a forward contract or a swap, exposes the derivative holder to the risk that the counterparty may default 9. Derivatives are often criticized by investors with limited knowledge of complex financial securities. A common criticism of 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 due to the high leverage involved in the payoffs. One of the benefits of derivatives is that they reduce transactions costs. Another benefit of derivatives is that they allow risk to be managed and shifted among market participants 10. MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the earnings announcement the value of MBT common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than expected news. This gradual change in the value of the stock is an example of: A)speculation. B)efficient markets. C)inefficient markets Explanation: C — A critical element of efficient markets is that asset prices respond immediately to any new information that will affect their value. Large numbers of traders responding in similar fashion to the new information will create a temporary imbalance in supply and demand, and this will adjust asset market 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 efficiency through the use of arbitrage. C)narrow the amount of trading opportunities to a more manageable range Explanation: C — Financial derivatives increase the opportunities to either speculate or hedge on the value of underlying assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders 12. Which of the following statements about arbitrage is NOT correct A)Arbitrage can cause markets to be less efficient. B)No investment is required when engaging in arbitrage. C)If an arbitrage opportunity exists, making a profit without risk is possible Explanation: A — Arbitrage is defined as the existence of riskless profit without investment and involves selling an asset and 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 efficient because price discrepancies are immediately 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 by those unfamiliar with the benefits of options markets and how derivatives 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 most efficiently bear it Explanation: B — The existence of derivatives markets does not affect 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 to understand Explanation: C — The fact that derivative securities are sometimes complex and often hard for non-financial commentators to understand has led to criticism of derivatives and derivative markets 16. Which of the following relationships between arbitrage and market efficiency is least accurate? A)The concept of rationally priced financial instruments preventing arbitrage opportunities is the basis behind the no-arbitrage principle. B)Market efficiency refers to the low cost of trading derivatives because of the lower expense to traders. C)Investors acting on arbitrage opportunities help keep markets efficient Explanation: B — Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer to the cost of trading. One necessary criterion for market efficiency is rapid adjustment of market values to new information. Arbitrage, trading on a price difference between identical assets, causes changes in demand for and supply of the assets that tends to eliminate the pricing difference 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 must be no risk in the trade. It doesn’t matter if commissions are paid as long as the amount of the price discrepancy is enough to offset the amount paid in commissions. In order to be considered arbitrage there must be no initial investment of one’s own capital. One must finance any cash outlay 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 afford. Explanation: A — Since any observed pricing errors will be instantaneously 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, which states that any rational price for a financial instrument must exclude arbitrage opportunities. The no-arbitrage opportunity assumption is the basic requirement for rational prices in the financial markets. This means that markets and prices are efficient. That is, all relevant information is impounded in the asset’s price. With arbitrage and efficient markets, you can create the option and 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 to make a riskless profit with no investment. In essence, finding an arbitrage opportunity is like finding free money. As you recall, in arbitrage, you observe two identical assets with different prices. Your immediate response should be to buy the cheaper one and sell 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 profit is locked in. The no-investment statement referenced in the text refers to the assumption that when you short the expensive asset, you will be given access to the cash created by the short sale. With this cash, you now have the money to buy the cheaper asset. The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves 20. The process that ensures that two securities positions with identical future payoffs, regardless of future events, will have the same price is called: A)arbitrage. B)exchange parity. C)the law of one price Explanation: A — If two securities have identical payoffs regardless of events, the process of arbitrage will move prices toward equality. Arbitrageurs will buy the lower priced position and sell the higher priced position, for an immediate profit without any future liability. The law of one price (for securities with identical payoffs) is not a process; it is ‘enforced’ by arbitrage 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 call option on an identical share. B)A portfolio of two securities that will produce a certain return that is greater than the risk-free rate of interest. C)A stock with the same price as another has a higher rate of return Explanation: B — An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless rate to purchase the position will produce a certain future amount greater than the amount required to repay the loan 22. The process of arbitrage does all of the following EXCEPT: A)promote pricing efficiency. B)produce riskless profits. C)insure that risk-adjusted expected returns are equal Explanation: C — Arbitrage does not insure that the risk-adjusted expected returns to two risky assets will be equal. Arbitrage is based on risk-free portfolios and promotes efficient pricing of assets. When an arbitrage opportunity is presented by a mispricing of assets, the increased supply of the ‘overpriced’ asset and the increased demand for the ‘underpriced’ asset by arbitrageurs, will move the prices toward equality and act to correct 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 forward contracts that trade on organized exchanges. Other types of forward contracts, as well as swaps, are custom instruments that are generally not exchange-traded