1. What is the primary reason for the development of exotic options?
A. To simplify hedging for firms
B. To provide a unique hedge for a firm’s underlying assets
C. To reduce transaction costs in exchanges
D. To improve liquidity in the market
Exotic options were developed mainly to provide firms with unique hedging solutions for their underlying assets that plain vanilla options cannot address.
2. Which of the following is a key feature that differentiates exotic options from plain vanilla options?
A. Exotic options are traded on exchanges
B. Exotic options have a fixed strike price
C. Exotic options are more liquid in the market
D. Exotic options are customized and traded in the OTC markets
Exotic options are customized and often traded in over-the-counter (OTC) markets, unlike plain vanilla options, which are typically traded on exchanges with more liquidity.
3. Which of the following is NOT a typical feature of plain vanilla options?
A. Uncertainty about the cost
B. Clear understanding of the market value
C. Fixed time of exercise
D. Easily tradable in liquid markets
Plain vanilla options have clear and predictable characteristics, including fixed costs, market value, exercise time, and liquidity. Exotic options, however, have more uncertainty.
4. Why are exotic options sometimes created in response to regulatory and tax concerns?
A. To increase the complexity of market transactions
B. To reduce regulatory oversight
C. To address tax and regulatory concerns
D. To make the markets more transparent
Exotic options can be structured to address specific tax and regulatory concerns, which may not be easily addressed by plain vanilla options.
5. What type of market factors might firms speculate on using exotic options?
A. Interest rates and commodity prices
B. Interest rates and exchange rates
C. Stock prices and corporate earnings
D. Real estate prices and inflation
Firms use exotic options to speculate on future movements in market factors such as interest rates and exchange rates, which can affect their business.
6. How do exotic options differ from plain vanilla options in terms of market exit strategy?
A. Exotic options may have uncertain exit strategies
B. Plain vanilla options always allow a fixed exit time
C. Both types of options have fixed exit strategies
D. Exotic options have no exit strategy
Exotic options may involve more uncertainty about how and when the position can be exited, compared to the predictable exit strategies of plain vanilla options.
7. What is the main market where exotic options are typically traded?
A. Over-the-counter (OTC) markets
B. Futures exchanges
C. Commodities exchanges
D. Stock exchanges
Exotic options are mostly traded in over-the-counter (OTC) markets, allowing for more customization compared to exchange-traded plain vanilla options.
8. What is a "zero-cost product" in the context of derivatives?
A. A product where the investor’s net cost for implementing the strategy is zero
B. A product with no initial premium
C. A product that guarantees zero profit
D. A product with unlimited upside potential
A zero-cost product is one where the investor's net cost is zero, achieved by offsetting the cost of a long position with the inflow from a short position.
9. Which of the following is an example of a derivative package that can be converted into a zero-cost product?
A. European call option only
B. Bullish option spread
C. A combination of long and short positions in European options, such as a bull, bear, or calendar spread
D. An option with a high upfront premium
Packages consisting of long and short positions in options, like bull, bear, or calendar spreads, can be constructed in such a way that their initial cost is zero.
10. In a zero-cost short collar, how is the cost of the options managed?
A. The put option premium is higher than the call option premium
B. The premium paid for the put option is exactly offset by the premium received for the short call option
C. The call option premium is higher than the put option premium
D. The cost is offset by the exercise prices of the options
In a zero-cost short collar, the investor's net cost is zero because the premium paid for the long put option is exactly balanced by the premium received from the short call option.
11. How can an option be structured as zero-cost besides using a package?
A. By choosing an option with no expiry
B. By using only American options
C. By ensuring it is a futures-style option
D. By deferring the premium payment to the expiration date of the option
An option can be structured as zero-cost by deferring the premium payment until the expiration date, where the total payment is adjusted for interest accrual.
12. What is the difference between futures-style and equity-style options in terms of payment?
A. Futures-style options defer the premium payment until expiration, while equity-style options require an upfront premium
B. Both require the payment of an upfront premium
C. Futures-style options require no premium payment
D. Equity-style options require payment of a deferred premium
Futures-style options differ from equity-style options because they allow the premium to be deferred to expiration, whereas equity-style options require an upfront premium.
13. What is the payoff formula for a European call option when the premium is deferred?
A. max(ST - X + A, -A)
B. max(ST - X, A)
C. max(ST - X - A, -A)
D. max(ST - A, X)
When the premium is deferred, the payoff on a European call option is calculated as max(ST - X - A, -A), where A is the deferred premium.
14. Which of the following strategies involves using a combination of long and short positions to create a zero-cost product?
A. Long futures position
B. A spread strategy like bull, bear, or calendar spread
C. Naked call option
D. Butterfly spread with a fixed premium
A spread strategy, such as bull, bear, or calendar spreads, involves both long and short positions in options that can be structured to result in a zero-cost product.
15. What makes an American option a nonstandard option?
A. The option can only be exercised on the last day of each month
B. The option cannot be exercised before expiration
C. Restricting the exercise to certain dates or changing other standard features of the option
D. The option is limited to a single strike price throughout its life
Nonstandard American options are those where exercise restrictions or other standard features are altered, such as limiting exercise to certain dates or adjusting strike prices during the life of the option.
16. Which of the following is an example of a nonstandard American option?
A. A Bermudan option where early exercise is restricted to certain dates
B. A European option that can only be exercised at expiration
C. A standard American option with no restrictions on exercise
D. An option with a fixed strike price for the duration of its life
A Bermudan option, where early exercise is restricted to specific dates, is an example of a nonstandard American option.
17. What feature distinguishes a Bermudan option from a standard American option?
A. The strike price changes over time
B. The exercise of the option is limited to certain dates
C. The option can only be exercised on expiration day
D. The option cannot be exercised at all
A Bermudan option restricts early exercise to specific dates, differentiating it from a standard American option, which can be exercised anytime before expiration.
18. Which of the following is a characteristic of nonstandard American options in the OTC market?
A. They are always exchange-traded
B. They have a fixed strike price throughout their life
C. They can only be exercised on expiration day
D. They are customized contracts with specific features like restricted exercise dates
Nonstandard American options, typically traded in the OTC market, are customized and can have features like restricted exercise dates or changing strike prices.
19. How does the transformation of standard American options into nonstandard options affect their exercise terms?
A. It allows for exercise only on a single specific date
B. It makes the options exerciseable at any time, like a European option
C. It limits the exercise to certain dates or changes other standard features like the strike price
D. It eliminates the right to exercise the option before expiration
Transforming standard American options into nonstandard ones may involve restricting exercise dates or modifying other features like the strike price.
20. Which type of option is likely to be customized with a changing strike price over its life?
A. A standard European option
B. A nonstandard American option
C. A plain vanilla call option
D. A standard American option with no restrictions
Nonstandard American options can have features like a changing strike price over their life, which distinguishes them from standard options.
21. What happens to the payoff of a gap call option when the stock price is greater than the trigger price (X2) but less than the initial strike price (X1)?
A. The payoff is equal to X1 minus the stock price
B. The payoff is reduced by X2 - X1
C. The payoff is zero
D. The payoff is equal to X1
When the stock price is greater than the trigger price (X2) but less than the initial strike price (X1), the gap call option's payoff is reduced by the difference between the two strike prices (X2 - X1).
22. What condition must be met for a gap call option to have a non-zero payoff?
A. The stock price must be greater than the trigger price (X2)
B. The stock price must be greater than the initial strike price (X1)
C. The stock price must be less than the trigger price (X2)
D. The stock price must be equal to the initial strike price (X1)
For a gap call option to have a non-zero payoff, the stock price at maturity must be greater than the trigger price (X2).
23. How does the payoff of a gap put option behave when the stock price is greater than or equal to the trigger price (X2)?
A. The payoff will be the stock price minus the initial strike price
B. The payoff will be zero
C. The payoff will be equal to X1 minus the stock price
D. The payoff will be negative
If the stock price is greater than or equal to the trigger price (X2), the payoff for a gap put option will be zero.
24. What occurs when the stock price of a gap put option is less than the trigger price (X2) but greater than or equal to the initial strike price (X1)?
A. The payoff will be reduced by X2 - X1
B. The payoff will be equal to X1 minus the stock price
C. The payoff will be equal to zero
D. The payoff will be negative
When the stock price is less than the trigger price (X2) but greater than or equal to the initial strike price (X1), the payoff for a gap put option will be reduced by the difference between the two strike prices (X2 - X1).
25. What is a key characteristic of the payoff graph of a gap option?
A. The payoff is always a straight line
B. There is a gap in the payoff graph where the strike prices differ
C. The payoff is equal to the difference between the strike prices
D. The payoff is zero for all stock prices
A key feature of the payoff graph of a gap option is the gap that occurs when the strike prices differ. The payoff is non-zero only when the stock price at maturity exceeds the trigger price.
26. What defines a Forward Start Option?
A. An option that starts its existence at a specified time in the future
B. An option that can be exercised only on its expiration date
C. An option that has a strike price equal to the underlying asset price
D. An option that is only available for employee incentive plans
A Forward Start Option begins its existence at a future date. For instance, an investor might purchase an option that only comes into effect six months later, but has the same characteristics as a European at-the-money option when it starts.
27. How does the value of a forward start option compare to the value of a European at-the-money option?
A. The value of the forward start option is always higher than the European option
B. The value of the forward start option will be identical to that of a European at-the-money option with the same time to expiration
C. The value of the forward start option will be lower than the European option
D. The value of the forward start option depends only on the strike price
When the underlying asset is a non-dividend-paying stock, the value of a forward start option is identical to the value of a European at-the-money option with the same expiration time.
28. Which of the following is an example of how cliquet options are structured?
A. A series of options with varying expiration times and strike prices
B. A combination of forward start options with adjustable strike prices at each period
C. A set of forward start options with specific guidelines on computing the exercise prices, such as multiple put options with staggered expiration dates
D. A series of call options with different strike prices
Cliquet options are structured as a set of forward start options with specific guidelines on how the exercise prices are calculated, often involving staggered expiration dates for options.
29. In the context of employee incentive plans, how are forward start options typically used?
A. As a way to avoid paying the employee for several months
B. As options that can be exercised immediately upon issuance
C. As options that have a very short lifespan
D. As options that are created after a certain period of employment has passed
Forward start options are often used in employee incentive plans, where the options are created after a certain period of employment, and the employee gains the right to exercise them after that waiting period.
30. What is one key characteristic of a cliquet option?
A. It only involves forward start call options
B. It includes a set of forward start options with predetermined expiration dates and strike prices
C. It is always based on a single underlying asset
D. It has an expiration date far in the future
A cliquet option is structured as a set of forward start options, where the expiration dates and strike prices are predetermined, creating a series of options over time.
31. What is a key characteristic of compound options?
A. Compound options give the right to buy an option on the underlying asset directly
B. Compound options consist of two strike prices and two exercise dates
C. Compound options are always European options
D. Compound options can only be exercised at maturity
Compound options consist of two strike prices and two exercise dates. The first strike price and exercise date are used to determine whether to exercise the first option and receive the second option on the underlying asset.
32. What is the payoff structure for a "call on a call" compound option?
A. The payoff is based on the value of the underlying asset directly
B. The payoff depends on the value of the first option (call option) on the underlying asset
C. The payoff is determined by the price at which the compound option was purchased
D. The payoff for a "call on a call" is always zero
The payoff for a "call on a call" compound option depends on the price of the first call option on the underlying asset. If this price exceeds the strike price of the initial compound option, the second option is exercised.
33. Which of the following represents a "call on a put" compound option?
A. The right to buy a call option at a set price
B. The right to buy a put option at a set price
C. The right to buy a put option at a set price for a specified period of time
D. The right to sell a put option at a set price for a set period of time
A "call on a put" is the right to buy a put option at a set price for a specific period of time. This is one type of compound option that provides additional leverage potential.
34. Which of the following is true for a "put on a put" compound option?
A. It gives the right to buy a call option at a set price for a set period of time
B. It gives the right to sell a call option at a set price for a set period of time
C. It gives the right to buy a put option at a set price for a specified period
D. It gives the right to sell a put option at a set price for a set period of time
A "put on a put" compound option gives the right to sell a put option at a set price for a specified period of time. This adds flexibility in managing risk.
35. How do compound options compare to standard options in terms of price sensitivity?
A. Compound options are less sensitive to price volatility
B. Compound options are more sensitive to price volatility fluctuations
C. Compound options are not affected by changes in price volatility
D. Compound options have no price sensitivity
Compound options are more sensitive to price volatility fluctuations compared to standard options because they involve two levels of options that can amplify price movements.
36. What is a key feature of chooser options?
A. The buyer chooses whether the option will be European or American after a specific period
B. The buyer can choose whether the option is a call or a put after a certain time has elapsed
C. The option can only be exercised at maturity
D. The buyer can change the strike price during the option’s life
A chooser option allows the buyer to choose whether the option will be a call or a put after a certain amount of time has passed but before expiration. This flexibility depends on the option's value at the time of choice.
37. How does a chooser option function in terms of its components?
A. It functions as a package of a call option and a put option, with different expiration dates and exercise prices
B. It functions as a package of two American options with different strike prices
C. It functions as an option where the buyer can modify the exercise price during its life
D. It functions as a single option with a dual strike price
A chooser option is structured as a combination of two European options: a call option with a fixed strike price and expiration date, and a put option with a present value strike price and a different expiration date.
38. When is the option type (call or put) chosen in a chooser option?
A. The type is chosen at the time of the option's purchase
B. The type is chosen at expiration
C. The type is chosen after a certain time has passed, but before expiration
D. The option type cannot be changed once the option is purchased
In a chooser option, the option type (call or put) is chosen after a specific time has passed but before expiration, based on which option (call or put) has the greater value at that time.
39. How is the exercise price of the put option determined in a chooser option?
A. It is equal to the strike price of the call option
B. It is a fixed value determined at the time of purchase
C. It is equal to the strike price of the put option at expiration
D. It is the present value of the strike price of the call option
In a chooser option, the exercise price of the put option is determined as the present value of the strike price of the call option. This provides flexibility in choosing which option to exercise.
40. What is the key benefit of a chooser option for an investor?
A. The ability to modify the strike price at any time
B. The ability to choose the option type (call or put) after a set period based on the option’s value
C. The ability to exercise the option before the specified time
D. The option can be used for both European and American style exercises
The main benefit of a chooser option is the ability for the investor to choose whether to exercise the option as a call or a put, depending on which option has the greater value after a specific period.
41. Which of the following describes a Down-and-Out call option?
A. A call option that comes into existence if the underlying asset price hits a barrier level above the current price
B. A call option that ceases to exist if the underlying asset price hits a barrier level above the current price
C. A call option that ceases to exist if the underlying asset price hits a barrier level below the current price
D. A call option that only comes into existence if the underlying asset price hits a barrier level below the current price
A Down-and-Out call option ceases to exist if the underlying asset price hits a barrier level below the current price. This is a type of barrier option that expires if the price moves past the specified barrier.
42. How does the value of a Down-and-Out option change with increasing volatility?
A. The value of a Down-and-Out option increases with increasing volatility
B. The value of a Down-and-Out option decreases with increasing volatility
C. The value of a Down-and-Out option remains unchanged with increasing volatility
D. The value of a Down-and-Out option becomes more volatile
For a Down-and-Out option, the value decreases with increasing volatility. This is because the closer the underlying asset price gets to the barrier level, the greater the chance of the option expiring worthless.
43. What is the payoff structure of a barrier option compared to a standard option?
A. Barrier options have a discontinuous payoff profile, unlike standard options
B. Barrier options have a continuous payoff profile, like standard options
C. Barrier options have a lower payoff at all times compared to standard options
D. Barrier options have the same payoff structure as binary options
Barrier options have a discontinuous payoff profile, meaning the payoff depends on whether the underlying asset hits the barrier level. This differs from standard options, which have continuous payoff profiles.
44. What is the relationship between a Down-and-Out call and a Down-and-In call?
A. The value of a Down-and-Out call is always higher than the value of a Down-and-In call
B. The value of a Down-and-Out call is the same as the value of a Down-and-In call
C. The value of a Down-and-Out call combined with the value of a Down-and-In call equals the value of a standard call option
D. The value of a Down-and-Out call and Down-and-In call cannot be combined
The value of a Down-and-Out call combined with the value of a Down-and-In call equals the value of a standard call option. This means that the combined values of these two barrier options can be used to calculate the value of a regular call option.
45. Which of the following is true for an Up-and-In call option?
A. The option comes into existence only if the underlying asset price falls below a specific barrier level
B. The option comes into existence only if the underlying asset price rises above a specific barrier level
C. The option ceases to exist if the underlying asset price rises above a specific barrier level
D. The option can be exercised immediately after the barrier level is hit
An Up-and-In call option only comes into existence if the underlying asset price rises above a specific barrier level. Once the barrier is breached, the option becomes active.
46. What defines the payoff profile of a Binary Option?
A. The payoff increases continuously with the price of the underlying asset
B. The payoff is always zero, regardless of the price of the underlying asset
C. The payoff is discontinuous, paying a fixed amount if the underlying asset is above the strike price
D. The payoff is equal to the difference between the strike price and the underlying asset price
Binary options generate a discontinuous payoff, where a fixed amount is paid if the underlying asset's price is above the strike price, and nothing is paid if it is below. The payoff is not continuous like standard options.
47. In a cash-or-nothing call option, what happens if the asset price is above the strike price at expiration?
A. No payment is made
B. A fixed amount, Q, is paid
C. The value of the underlying asset is paid
D. The option becomes worthless
In a cash-or-nothing call option, if the asset price is above the strike price at expiration, a fixed amount, Q, is paid, and no payment is made if the price is below the strike price.
48. How does the payoff structure of an asset-or-nothing call option differ from a cash-or-nothing call option?
A. The asset-or-nothing call option pays the value of the underlying asset if the price is above the strike price, while the cash-or-nothing call option pays a fixed amount
B. The asset-or-nothing call option has a continuous payoff, while the cash-or-nothing call has a discontinuous payoff
C. Both options have identical payoffs
D. The asset-or-nothing call option pays nothing if the price is above the strike price, while the cash-or-nothing call option pays the value of the underlying asset
In an asset-or-nothing call option, the value of the underlying asset is paid if the price is above the strike price at expiration. In contrast, a cash-or-nothing call option pays a fixed amount, Q, if the asset price is above the strike price.
49. In a European call option, what is the relationship between an asset-or-nothing call and a cash-or-nothing call?
A. The buyer is long both an asset-or-nothing call and a cash-or-nothing call with the same strike price
B. The buyer is short both an asset-or-nothing call and a cash-or-nothing call
C. The buyer is long an asset-or-nothing call and short a cash-or-nothing call with the exercise price as the payoff
D. The buyer is long a cash-or-nothing call and short an asset-or-nothing call
In a European call option, the buyer is long an asset-or-nothing call and short a cash-or-nothing call with the exercise price as the payoff. This relationship forms the basic structure of a European call option.
50. What is the key characteristic of binary options that differentiates them from traditional options?
A. Binary options pay a fixed amount at expiration, regardless of the asset's price level
B. Binary options have a continuous payoff based on the asset's price level
C. Binary options are only available for short-term investments
D. Binary options are always more expensive than traditional options
The key characteristic of binary options is that they pay a fixed amount at expiration, regardless of the asset's price level, creating a discontinuous payoff profile. This differs from traditional options, which have payoffs that change continuously with the underlying asset price.
51. What distinguishes a floating lookback call option from a standard European call option?
A. A floating lookback call uses the highest price during the option's life as the strike price
B. A floating lookback call allows the owner to purchase the asset at its highest price during the option's life
C. A floating lookback call allows the owner to purchase the asset at its lowest price during the option's life
D. A floating lookback call pays the difference between the final price and the maximum price during the option's life
A floating lookback call option pays the difference between the expiration price and the minimum price of the underlying asset over the life of the option, allowing the owner to purchase the security at its lowest price during the option's life.
52. How does a floating lookback put option work?
A. It allows the owner to sell the asset at its highest price during the option's life
B. It allows the owner to sell the asset at its lowest price during the option's life
C. It allows the owner to purchase the asset at its highest price during the option's life
D. It pays the difference between the strike price and the minimum price during the option's life
A floating lookback put option pays the difference between the expiration price and the maximum price of the underlying asset over the life of the option, allowing the owner to sell the security at its highest price during the option's life.
53. What is the main difference between a fixed lookback call and a standard European call option?
A. A fixed lookback call has the strike price set at the maximum price during the option's life
B. A fixed lookback call uses the expiration price as the strike price, just like a standard call
C. A fixed lookback call replaces the expiration price with the maximum price during the option's life
D. A fixed lookback call uses the minimum price during the option's life instead of the expiration price
A fixed lookback call has a payoff similar to a European call option, but instead of using the expiration price as the strike price, it uses the maximum price of the underlying asset during the option's life.
54. Why are lookback options generally more expensive than standard options?
A. They offer no additional benefits to the owner compared to standard options
B. They provide the owner with the potential to buy or sell at the most favorable price during the option's life
C. They have a continuous payoff structure
D. They have a fixed exercise price that is not dependent on the underlying asset price
Lookback options are more expensive than standard options because they give the owner the potential to buy or sell at the most favorable price during the option's life, adding value compared to traditional options.
55. What happens if the underlying asset is monitored more frequently in a lookback option?
A. The value of the lookback option increases
B. The value of the lookback option decreases
C. The payoff becomes less favorable for the holder
D. The option expires prematurely
The value of lookback options increases if the underlying asset is monitored more frequently. This allows the owner to potentially capitalize on favorable price movements during the life of the option.
56. What is the main characteristic of Asian options compared to standard options?
A. Asian options have payoffs based on the strike price rather than the average price of the asset
B. Asian options have more volatile payoffs compared to standard options
C. Asian options have payoffs based on the average price of the underlying asset over the life of the option
D. Asian options are more expensive than regular options
Asian options are unique because their payoffs depend on the average price of the underlying asset over the life of the option, unlike standard options that depend on the price at expiration. This results in a less volatile payoff profile.
57. How does the payoff of an average price call option differ from that of a standard European call option?
A. The payoff of an average price call depends on the average price of the underlying asset during the option's life, not just the expiration price
B. The payoff of an average price call depends solely on the expiration price of the underlying asset
C. The payoff of an average price call is less volatile than that of a European call
D. The payoff of an average price call is determined by the maximum price of the underlying asset
The payoff of an average price call option is based on the average price of the underlying asset over the life of the option, rather than just the expiration price as in a standard European call.
58. Why are Asian options generally cheaper than standard options?
A. They have less favorable payoffs
B. They are more volatile than standard options
C. Their payoffs are less volatile due to the use of the average price of the underlying asset
D. They do not require any premium payment
Asian options are cheaper than standard options because their payoff structure is based on the average price of the underlying asset, which is less volatile than the actual price, making the options less risky and thus less expensive.
59. What type of calculation is typically used to determine the average price in Asian options?
A. Arithmetic average
B. Geometric average
C. Median price
D. Moving average
The average price in Asian options is typically calculated using an arithmetic average of the underlying asset's price over the life of the option.
60. How can Asian options be more effective for hedging compared to regular options?
A. They provide higher returns than regular options
B. They are less likely to be exercised due to their average price structure
C. They are cheaper and more effective for hedging long-term exposure to fluctuations in the underlying asset price
D. They allow for early exercise, unlike regular options
Asian options are often cheaper than regular options, making them more effective for hedging long-term exposure to fluctuations in the underlying asset price, especially for firms with predictable exposure over time.
61. What is an exchange option typically used for?
A. To exchange one type of asset for another, such as exchanging one currency for another
B. To purchase multiple assets from a single trade
C. To sell an option on a specific security
D. To transfer ownership of a specific stock
An exchange option allows the exchange of one asset for another, such as converting one currency to another, based on a predefined exchange rate.
62. In the example of a U.S. investor with an option to purchase euros with yen, when will the option be exercised?
A. When the euro is worth less than the yen
B. When the yen becomes worthless
C. When euros are more valuable than yen to the investor
D. When the option expires
The option will be exercised when the euro becomes more valuable than the yen, allowing the U.S. investor to exchange yen for euros at the pre-specified exchange rate.
63. What is a basket option?
A. An option on a single stock
B. An option to purchase or sell a portfolio of multiple securities, such as stocks, indices, or currencies
C. A specific option to exchange one asset for another
D. An option that only covers the movement of a specific currency
A basket option allows an investor to purchase or sell multiple securities as a bundle, which could include stocks, indices, or currencies.
64. Why might basket options be cheaper than purchasing individual options on each security in the basket?
A. They require only one trade to cover multiple exposures, reducing transaction costs
B. They are always cheaper because they are simpler to execute
C. They have lower premiums due to lower volatility
D. They only cover securities with high correlation
Basket options may be cheaper than purchasing individual options because they require just one trade to cover exposure to multiple assets, potentially lowering transaction costs.
65. How does the correlation of returns between the underlying securities affect the price of a basket option?
A. The price remains unaffected by correlation
B. The price increases when there is less correlation between the assets
C. The price decreases when there is more correlation between the assets
D. The price is the same regardless of the correlation
The price of a basket option tends to be lower when there is a higher correlation of returns between the underlying securities, as the assets move in a more predictable manner.
66. What is a key difference between volatility swaps and variance swaps?
A. Volatility swaps are based on a notional principal, whereas variance swaps are not
B. Volatility swaps involve the exchange of volatility, while variance swaps involve the exchange of variance
C. Volatility swaps can be replicated with call and put options, while variance swaps cannot
D. Variance swaps are based on the price of the underlying asset, while volatility swaps are not
The key difference is that volatility swaps are based on the exchange of volatility, while variance swaps involve the exchange of variance, which is the square of volatility.
67. In a volatility swap, how is realized volatility calculated?
A. By multiplying daily volatility by the number of annual trading days
B. By dividing daily volatility by the square root of 252
C. By multiplying daily volatility by the square root of 252
D. By averaging daily volatility over a year
Realized volatility is calculated by multiplying daily volatility by the square root of 252, which is the estimate of the number of annual trading days.
68. Which of the following is true about variance swaps compared to volatility swaps?
A. Variance swaps are more difficult to price and hedge than volatility swaps
B. Variance swaps are easier to price and hedge because they can be replicated using call and put options
C. Variance swaps require more complex calculations to determine the payoff
D. Volatility swaps are more liquid than variance swaps
Variance swaps are easier to price and hedge than volatility swaps because they can be replicated using a collection of call and put options.
69. Which of the following best describes a volatility swap?
A. A contract that involves a bet on the volatility of an asset, with the payoff based on the difference between fixed and realized volatility
B. A contract where the payoff depends on the underlying asset's price movements
C. A contract that involves the exchange of one asset for another based on volatility
D. A contract where the payoff is based on the variance of the asset
A volatility swap is a contract where the payoff is based on the difference between fixed volatility and the realized volatility of an asset.
70. Why might an investor prefer a variance swap over a volatility swap?
A. Variance swaps are harder to price and hedge
B. Variance swaps involve more complex payoffs
C. Variance swaps are easier to price and hedge using call and put options
D. Volatility swaps provide better liquidity than variance swaps
Variance swaps are preferred by some investors because they are easier to price and hedge, and they can be replicated using a combination of call and put options.
71. What is the basic premise of static option replication in the context of hedging exotic options?
A. It involves creating a dynamic portfolio that adjusts regularly based on option Greeks.
B. It replicates an option portfolio that changes continuously based on changes in the underlying asset.
C. It involves creating a short portfolio of actively traded options that approximates the exotic option's position and remains unchanged until the barrier is reached.
D. It involves hedging an option position using only vanilla options without any need for adjustments.
Static option replication involves creating a portfolio of actively traded options that approximates the exotic option position, and this portfolio is not adjusted until the relevant barrier is reached, at which point it is unwound and a new portfolio is created.
72. How does hedging with static option replication differ from dynamic option hedging?
A. Dynamic hedging involves creating a portfolio with fixed option positions, while static hedging adjusts the portfolio based on price movements.
B. Dynamic hedging uses option Greeks to continuously adjust the portfolio, while static hedging involves creating a fixed portfolio without adjustments until a barrier is hit.
C. Static hedging is more complex as it requires constant adjustments to option positions, while dynamic hedging does not.
D. Static hedging adjusts portfolios based on the delta of an option, while dynamic hedging focuses solely on the gamma.
In static hedging, the portfolio is constructed once and remains unchanged until the relevant barrier is reached. Dynamic hedging, on the other hand, continuously adjusts the portfolio based on changes in option Greeks, such as delta and gamma.
73. Why is static option replication more suitable for hedging barrier options compared to dynamic hedging?
A. Barrier options have less price sensitivity, making dynamic hedging unnecessary.
B. Barrier options have more complex payoffs, making continuous adjustments in the portfolio difficult and inefficient.
C. Barrier options can be effectively replicated with a constant portfolio of long options, which simplifies hedging.
D. Static option replication involves hedging exotic options without needing to make any changes to the portfolio.
Static option replication is better suited for barrier options because their payoff structure is complex, and continuously adjusting the hedging portfolio is challenging. Instead, a fixed short portfolio can be created and adjusted only when the barrier is hit.
74. In a static option replication strategy, when would the hedging portfolio need to be unwound and rebuilt?
A. When the price of the underlying asset changes.
B. When the option's time to maturity reaches a specified threshold.
C. When the volatility of the underlying asset reaches a predefined level.
D. When the relevant barrier is reached (for example, in a barrier option).
In a static option replication strategy, the hedging portfolio needs to be unwound and rebuilt when the relevant barrier is reached, as this is when the payoff structure changes significantly.
75. What is a key advantage of using static option replication for hedging exotic options?
A. It allows for continuous rebalancing of the portfolio based on market conditions.
B. It reduces the complexity of hedging compared to dynamic strategies.
C. It provides a simple and cost-effective solution for hedging exotic options, especially when dealing with complex payoff structures like barriers.
D. It eliminates the need for monitoring market conditions entirely.
Static option replication simplifies the hedging process, making it a cost-effective and straightforward approach, especially for exotic options with complex payoffs like barrier options, where continuous adjustments are difficult.
76. A down-and-in call option comes into existence only when the underlying asset price:
A. Rises to a set barrier level.
B. Falls to a set barrier level.
C. Falls to a set average barrier level.
D. Rises to a set average barrier level.
A down-and-in call option is a type of barrier option that only comes into existence when the price of the underlying asset falls to a specified barrier level.
77. A cash-or-nothing put option has a payout profile equivalent to zero or:
A. The underlying asset price if the value of the asset ends below the strike price.
B. The underlying asset price if the value of the asset ends above the strike price.
C. A set amount if the value of the asset ends below the strike price.
D. A set amount if the value of the asset ends above the strike price.
A cash-or-nothing put option pays a fixed amount if the underlying asset price ends below the strike price; otherwise, the payout is zero.
78. An Asian option can be hedged dynamically because:
A. The average value of the underlying asset price decreases uncertainty the closer the option gets to expiration.
B. The average value of the underlying asset price increases uncertainty the closer the option gets to expiration.
C. The maximum value of the underlying asset price decreases uncertainty the closer the option gets to expiration.
D. The minimum value of the underlying asset price increases uncertainty the closer the option gets to expiration.
Asian options are less sensitive to price fluctuations as their payoff depends on the average value of the underlying. As the option approaches expiration, the uncertainty in the average price decreases.
79. Which of the following options is most likely to have a negative vega?
A. A chooser option close to expiration.
B. A forward start put option before the start date.
C. An Asian put option close to the beginning of the option’s life.
D. An up-and-out put when the stock price is close to the barrier.
A forward start put option, before the start date, would have a negative vega as its value decreases when implied volatility increases, due to its delayed maturity.
80. Under which of the following circumstances would the value of an up-and-out call option be zero?
A. The strike price is above the barrier price.
B. The stock price is below the barrier price.
C. The stock price is above the strike price.
D. The stock price is below the strike price.
An up-and-out call option becomes worthless when the underlying asset price never reaches the specified barrier level, so if the stock price is below the barrier, the option will have zero value.
