Chapter 4 - Introduction to Derivatives (FRM Part 1 - Book 3)
Chapter 4 - Introduction to DerivativesOption & Forward Payoff Chart
Chapter 4 - Introduction to Derivatives
Payoff Chart: Options & Forward Contract
1. What is an underlying asset in the context of derivatives?
A. The security from which a derivative derives its value
B. A type of fixed-income instrument
C. The final maturity value of a derivative
D. A guaranteed return on a derivative
An underlying asset is the security from which a derivative derives its value.
2. Which of the following is a linear derivative?
A. Call option
B. Futures contract
C. Put option
D. Stock option
Futures contracts are linear derivatives because their payoff is directly related to the underlying asset's value.
3. Which of the following best describes the payoff of a nonlinear derivative?
A. Always equal to the underlying asset’s return
B. Proportional to interest rate changes
C. Depends on the right but not obligation to act
D. Fixed regardless of market conditions
Nonlinear derivatives like options provide the right but not the obligation to act, resulting in a nonlinear payoff.
4. In a derivative contract, which of the following parties benefits when the other loses?
A. Both parties always benefit
B. Only the buyer
C. Only the seller
D. One party benefits exactly what the other loses
Derivatives like forwards and futures are zero-sum games—one party gains exactly what the other loses.
5. Which of the following is not a use of derivatives?
A. Risk management
B. Speculation
C. Determining stock dividends
D. Diversification of exposure
Derivatives are not used for determining stock dividends. They are used for hedging, speculation, and diversification.
6. What is the key characteristic of the open outcry system in derivatives trading?
A. Fully automated matching of buyers and sellers
B. Traders use hand signals and shouting to indicate trades
C. Use of blockchain technology for clearing
D. Trade execution via mobile apps only
The open outcry system involves physical interaction, where traders use hand signals and shouting to communicate trades.
7. Which market type typically involves larger trade sizes?
A. Traditional exchange
B. Futures exchange
C. Over-the-counter (OTC) market
D. Commodity spot market
OTC markets typically involve much larger trades compared to traditional exchange markets.
8. What is one key advantage of OTC derivative trading?
A. Customization of contract terms
B. Lower credit risk than exchanges
C. Trades can never be reported
D. Physical location is mandatory
One of the major advantages of OTC trading is the ability to customize contract terms since they are not standardized by an exchange.
9. Why does OTC trading carry more credit risk than exchange trading?
A. Because trades are executed faster
B. Because regulations do not apply
C. Because of standardization
D. Because OTC trades lack centralized clearing
OTC trading has more credit risk as many trades are non-standardized and not cleared through a central counterparty like in exchanges.
10. What is one major difference between electronic trading and OTC trading?
A. Electronic trading always uses brokers
B. OTC trades may be customized while electronic trades are standardized
C. Electronic trades carry higher credit risk
D. OTC trades cannot be reported to regulators
OTC trades can be customized according to the parties' needs, whereas electronic trades on exchanges are typically standardized.
11. What does a call option give the holder the right to do?
A. Buy the underlying asset at the strike price
B. Sell the underlying asset at the market price
C. Exchange the asset at a variable rate
D. Cancel a trade without cost
A call option provides the holder the right (not the obligation) to purchase the asset at the strike price before expiration.
12. What is a distinguishing feature of a European-style option?
A. It can be exercised any time before expiration
B. It can be exercised only on the expiration date
C. It has no expiration date
D. It is traded only on European exchanges
A European-style option can be exercised only on the expiration date, unlike American-style options.
13. Which of the following statements is true regarding forward contracts?
A. They are always traded on exchanges
B. They are highly standardized
C. They are traded OTC and are customizable
D. Only corporations can use them
Forward contracts are OTC instruments, allowing for customization in terms and conditions.
14. Which of the following correctly distinguishes futures contracts from forward contracts?
A. Futures contracts are customizable
B. Futures contracts are OTC-based
C. Forward contracts are always standardized
D. Futures contracts are standardized and exchange-traded
Futures contracts are traded on exchanges and are standardized by nature regarding contract specifications.
15. Which of the following best explains why American-style options are often worth more than European-style options?
A. American options are always traded OTC
B. European options are illegal in some countries
C. American options allow early exercise, adding value
D. European options can only be used by governments
The right to early exercise makes American options more valuable when early exercise has financial benefits.
16. What is the payoff formula for a call option buyer?
A. CT = X − ST
B. CT = max(0, ST − X)
C. CT = ST − X
D. CT = X − max(0, ST)
The payoff to the option buyer is calculated as CT = max(0, ST − X), where ST is the stock price at maturity and X is the strike price.
17. What is the formula for the profit of the call option buyer?
A. Profit = C0 − CT
B. Profit = ST − X
C. Profit = CT − X
D. Profit = CT − C0
The profit to the call option buyer is calculated as Profit = CT − C0, where C0 is the call premium and CT is the payoff on the call option.
18. What is the formula for the profit of the call option seller?
A. Profit = CT − C0
B. Profit = C0 − X
C. Profit = C0 − CT
D. Profit = ST − X
The profit to the call option seller is Profit = C0 − CT, where C0 is the call premium and CT is the payoff to the buyer.
19. If the stock price at maturity (ST) is $120 and the strike price (X) is $100, what is the payoff on the call option?
A. $20
B. $0
C. $100
D. $120
The payoff is calculated as CT = max(0, ST − X). In this case, CT = max(0, 120 − 100) = $20.
20. If the call option premium (C0) is $5 and the stock price at maturity (ST) is $120 with a strike price (X) of $100, what is the profit to the option buyer?
A. $15
B. $5
C. $20
D. $0
The profit to the buyer is calculated as Profit = CT − C0. Here, Profit = 20 − 5 = $15.
21. What is the payoff formula for a put option buyer?
A. PT = max(0, ST − X)
B. PT = max(0, X − ST)
C. PT = ST − X
D. PT = X − max(0, ST)
The payoff to the option buyer is calculated as PT = max(0, X − ST), where ST is the stock price at maturity and X is the strike price.
22. What is the formula for the profit of the put option buyer?
A. Profit = C0 − PT
B. Profit = ST − X
C. Profit = PT − X
D. Profit = PT − P0
The profit to the put option buyer is calculated as Profit = PT − P0, where P0 is the put premium and PT is the payoff on the put option.
23. What is the formula for the profit of the put option seller?
A. Profit = P0 − PT
B. Profit = PT − C0
C. Profit = P0 − PT
D. Profit = ST − X
The profit to the put option seller is calculated as Profit = P0 − PT, where P0 is the put premium and PT is the payoff to the buyer.
24. If the stock price at maturity (ST) is $80 and the strike price (X) is $100, what is the payoff on the put option?
A. $100
B. $20
C. $0
D. $80
The payoff is calculated as PT = max(0, X − ST). In this case, PT = max(0, 100 − 80) = $20.
25. If the put option premium (P0) is $5 and the stock price at maturity (ST) is $80 with a strike price (X) of $100, what is the profit to the option buyer?
A. $15
B. $0
C. $5
D. $20
The profit to the buyer is calculated as Profit = PT − P0. Here, Profit = 20 − 5 = $15.
26. What is the payoff formula for a long position in a forward contract?
A. Payoff = K − ST
B. Payoff = ST − K
C. Payoff = K
D. Payoff = K × ST
The payoff to a long position in a forward contract is calculated as: Payoff = ST − K, where ST is the spot price at maturity and K is the delivery price.
27. What is the payoff formula for a short position in a forward contract?
A. Payoff = ST − K
B. Payoff = K × ST
C. Payoff = K − ST
D. Payoff = K
The payoff to a short position in a forward contract is calculated as: Payoff = K − ST, where ST is the spot price at maturity and K is the delivery price.
28. If the spot price at maturity (ST) is $150 and the delivery price (K) is $100, what is the payoff for a long position in the forward contract?
A. $50
B. $150
C. $100
D. $250
The payoff to the long position is calculated as: Payoff = ST − K = 150 − 100 = $50.
29. If the spot price at maturity (ST) is $80 and the delivery price (K) is $100, what is the payoff for a short position in the forward contract?
A. $20
B. $80
C. $20
D. −$20
The payoff to the short position is calculated as: Payoff = K − ST = 100 − 80 = $20.
30. If the spot price at maturity (ST) is $120 and the delivery price (K) is $130, what is the payoff for a short position in the forward contract?
A. $130
B. $10
C. −$10
D. −$10
The payoff to the short position is calculated as: Payoff = K − ST = 130 − 120 = $10, but since the short position is at a loss when ST is higher than K, the payoff is −$10.
31. What is the primary objective of a hedger using forward contracts?
A. To make a profit from price movements
B. To neutralize risk by fixing the price of an underlying asset
C. To speculate on future price movements
D. To lock in a riskless profit from mispricings
The primary objective of a hedger using forward contracts is to neutralize risk by fixing the price at which the underlying asset will be bought or sold in the future.
32. How do options help hedgers manage risk?
A. By fixing the price of the underlying asset
B. By neutralizing price movements
C. By providing insurance against downside risk while allowing for upside potential
D. By speculating on price movement
Hedgers use options as a form of insurance against downside risk while keeping some of the upside potential. This allows for limited losses but the possibility of profit.
33. What is the primary goal of a speculator using options?
A. To bet on future price movements with magnified potential gains
B. To neutralize risk without any cost
C. To lock in a riskless profit by taking offsetting positions
D. To fix the price at which they will buy or sell an asset
Speculators use options to bet on future price movements, with the potential for magnified gains. Their maximum loss is limited to the cost of the options.
34. What do arbitrageurs seek to exploit in financial markets?
A. Hedging risk
B. Future price movements
C. Downside risk protection
D. Mispricings in different markets to lock in a riskless profit
Arbitrageurs seek to exploit mispricings in the same asset across different markets, allowing them to lock in a riskless profit by taking offsetting positions.
35. Which of the following describes the maximum loss for a speculator using options?
A. Unlimited
B. The cost of the underlying asset
C. The dollar investment in options
D. The premium paid for the options
The maximum loss for a speculator using options is limited to the dollar investment in the options, as they can only lose what they paid for the options themselves.
36. What is a key difference between forward contracts and options in hedging?
A. Forward contracts provide downside protection only
B. Options allow upside potential while providing downside protection
C. Forward contracts require a premium payment
D. Options lock in a fixed price
Options offer downside protection (like insurance) while still allowing the investor to benefit if prices move favorably. This is unlike forwards, which lock in a price.
37. Which of the following best describes the payoff from a forward contract?
A. Linear with respect to price movement of the underlying
B. Limited to the premium paid
C. Limited to price increases only
D. Always results in a profit
The payoff from a forward contract is linear — it increases or decreases directly with the price of the underlying asset.
38. Why might a hedger prefer options over forward contracts?
A. Options always give higher returns
B. Forwards are more expensive
C. Options allow benefit from favorable price movements
D. Forwards provide no hedging benefits
Options provide hedging with the added benefit that the investor can profit if the market moves favorably, unlike forwards which fix the price.
39. What is the cost associated with buying an option for hedging?
A. There is no cost
B. The difference in spot and strike price
C. The interest on margin
D. The option premium
The option premium is the cost paid by the hedger to buy an option. This acts like insurance against adverse price movements.
40. An investor with a short exposure to an asset can hedge by:
A. Entering a short futures contract
B. Entering a long futures contract
C. Buying a put option
D. Selling a call option
A short exposure means the investor is at risk if prices rise. Buying futures or call options helps hedge this risk.
41. What is the primary motivation of a speculator using derivatives?
A. Hedging risk exposure
B. Locking in prices for future trades
C. Making profits by betting on market movements
D. Reducing investment leverage
Speculators use derivatives like futures and options to profit from anticipated price movements, not to hedge risk.
42. How do futures contracts create leverage for speculators?
A. Only a small margin is required compared to the full contract value
B. Futures have no associated risk
C. Speculators pay only the premium
D. Futures are government-backed
Futures require only an initial margin deposit, which is a small percentage of the contract’s full value, leading to high leverage.
43. What is a key characteristic of futures contract payoffs for speculators?
A. Limited losses and unlimited gains
B. Only downside risks
C. Capped profits
D. Symmetrical payoffs
Futures contracts provide symmetrical payoffs, meaning profits and losses are unlimited and directly mirror price movements.
44. How are losses limited when speculators go long on options?
A. Losses are capped at strike price
B. Losses are limited to the premium paid
C. Losses are insured by exchange
D. There is no loss in options trading
For long option positions, the maximum loss is the premium paid to acquire the option. This makes options attractive for speculative strategies.
45. Compared to futures, how do option payoffs differ for speculators?
A. Options provide symmetrical payoffs
B. Options eliminate risk completely
C. Options offer asymmetrical payoffs
D. Option losses are larger than futures
Options offer asymmetrical payoffs: limited downside (premium paid) with the potential for large gains, unlike symmetrical futures.
46. What is the goal of an arbitrageur in the derivatives market?
A. To earn risk-free profit through price inefficiencies
B. To hedge long-term exposures
C. To speculate on price movements
D. To pay premiums for protection
Arbitrageurs aim to earn risk-free profits by taking advantage of temporary price differences in different markets or instruments.
47. How do arbitrageurs typically structure their trades?
A. By taking unhedged long positions only
B. By paying option premiums
C. By entering into equivalent offsetting positions
D. By buying low and holding long term
Arbitrageurs enter into offsetting positions in one or more markets to lock in a riskless profit from pricing inefficiencies.
48. Why are arbitrage opportunities usually short-lived?
A. Government intervention
B. Market forces quickly adjust prices
C. Regulatory price ceilings
D. Limited access to capital
Supply and demand forces act rapidly to remove price mismatches, making arbitrage opportunities temporary.
49. What type of profit is generally associated with arbitrage strategies?
A. Speculative profit with high risk
B. Premium-based gain
C. Hedged gain from insurance
D. Risk-free profit
Arbitrage strategies are designed to exploit mispricings for a profit that is essentially risk-free.
50. Which of the following is NOT typically true about arbitrage opportunities?
A. They persist for long periods
B. They are eliminated by price adjustments
C. They involve offsetting positions
D. They can offer risk-free gains
Arbitrage opportunities are short-term phenomena and do not persist for long periods due to market corrections.
51. What is the main risk associated with derivatives when used for speculation?
A. Catastrophic losses if the market moves against the position
B. Lower liquidity compared to stocks
C. Increased complexity in pricing models
D. Increased capital requirements
Speculation in derivatives can lead to massive losses if the market moves in the opposite direction, as seen in historical cases like Barings Bank.
52. Which of the following describes operational risk when using derivatives?
A. Losses from insufficient liquidity
B. Unauthorized use of derivatives for speculation instead of hedging
C. Losses due to incorrect pricing models
D. Unpredictable market volatility
Operational risk arises when a trader misuses derivatives, either by speculating instead of hedging or violating company risk controls.
53. What is a key factor in preventing risks from the misuse of derivatives within corporations?
A. Increasing exposure to high-risk assets
B. Reducing the use of financial controls
C. Establishing and monitoring strict controls and risk limits
D. Allowing more flexibility in trading decisions
To prevent misuse, corporations need strong risk management frameworks, such as controls and limits that are strictly monitored.
54. What happened to Barings Bank as a result of derivative risks?
A. It became one of the largest global banks
B. It had a smooth transition to a digital banking model
C. It successfully hedged all its derivative positions
D. It collapsed due to catastrophic losses from unauthorized derivative speculation
Barings Bank collapsed in 1995 due to massive losses from unauthorized speculative derivative trading by a rogue trader.
55. Which of the following is the most effective way to mitigate the risks associated with derivatives?
A. Use derivatives only for speculative purposes
B. Avoid using derivatives in corporate portfolios
C. Establish risk limits and ensure strict compliance with controls
D. Allow traders full discretion in executing derivative trades
Effective risk management practices, such as setting risk limits and ensuring adherence to controls, are essential in mitigating derivative risks.
56. Which of the following best describes the risk associated with the misuse of derivatives in financial institutions?
A. The misuse of derivatives poses a significant risk only for major financial institutions.
B. Speculation through derivatives should be completely prohibited to prevent large-scale losses.
C. The leverage in derivatives can make profits larger, while significantly reducing potential losses.
D. Differentiating between arbitrage and speculative activities in derivatives can often be challenging.
The main difficulty in using derivatives arises from the overlap between arbitrage and speculative activities, making it hard to distinguish between the two.
57. What is the role of an individual who quotes both the buying and selling prices of a security, and is ready to execute transactions for it?
A. A hedger, seeking to reduce risk.
B. An arbitrageur, who exploits price discrepancies between markets.
C. A speculator, aiming to profit from price movements.
D. A dealer, who facilitates market liquidity by buying and selling securities.
A dealer quotes both bid and ask prices for a security and stands ready to buy or sell to facilitate market liquidity.
