Hull: Options, Futures, and Other Derivatives, Ninth Edition

Chapter 1: Introduction
Multiple Choice Test Bank: uestions !ith "ns!ers

1. A one-year
one-year forwar
forward
d contract
contract is an agreement
agreement wher
wheree
A. One side has the right to buy
buy an asset for a certain price
price in one year’s
year’s
time.
B. One side has the obligation to buy an asset
asset for a certain
certain price in one
one
year’s time.
C. One side has the obligation to buy an asset
asset for a certain
certain price at some
some
time during the next year.
D. One side has the obligation to buy an asset
asset for the maret
maret price
price in one
year’s time.

Answer! B
A one-year forward contract is an obligation to buy or sell in one year’s time
for a predetermined price. By contrast" an option is the right to buy or sell.

#. $hich
$hich of the following
following is %O&
%O& true
true
A. $hen a CBO' call option on (B) is exercised"
exercised" (B) issues more stoc
stoc
B. An American option can
can be exercised
exercised at any time during its
its life
C. An call option will always be exerc
exercised
ised at maturity
maturity if the underlying
underlying
asset price is greater than the strie price
D. A put option will always be exercised
exercised at maturity if the strie price is
greater than the underlying asset price.

Answer! A
$hen an (B) call option is exercised the option seller must buy shares in the
maret to sell to the option buyer. (B) is not in*ol*ed in any way. Answers B"
C" and D are true.

+. A one-yea
one-yearr call option
option on a stoc
stoc with
with a stri
strie
e price
price of ,+ costs
costs ,+
,+ a one-
one-
year put option on the stoc with a strie price of ,+ costs ,/. 0uppose that
a trader buys two call options and one put option. &he breae*en stoc price
abo*e which the trader maes a prot is
A. ,+2
B. ,/
C. ,+
D. ,+3

Answer! A
$hen the stoc price is ,+2" the two call options pro*ide a payo4 of
#56+27+8 or ,1. &he put option pro*ides no payo4. &he total cost of the
options is #5+9 / or ,1. &he stoc price in A" ,+2"
,+2" is therefore
therefore the
breae*en stoc price abo*e which the position is protable because it is the
price for which the cost of the options e:uals the payo4.
/. A one-year call option on a stoc with a strie price of ,+ costs ,+ a one-
year put option on the stoc with a strie price of ,+ costs ,/. 0uppose that
a trader buys two call options and one put option. &he breae*en stoc price
below which the trader maes a prot is
A. ,#2
B. ,#;
C. ,#3
D. ,#

Answer! D
$hen the stoc price is ,# the two call options pro*ide no payo4. &he put
option pro*ides a payo4 of +7# or ,1. &he total cost of the options is
#5+9 / or ,1. &he stoc price in D" ,#" is therefore the breae*en stoc
price below which the position is protable because it is the price for which
the cost of the options e:uals the payo4.

2. $hich of the following is approximately true when si<e is measured in terms

of the underlying principal amounts or *alue of the underlying assets
A. &he exchange-traded maret is twice as big as the o*er-the-counter
maret.
B. &he o*er-the-counter maret is twice as big as the exchange-traded
maret.
C. &he exchange-traded maret is ten times as big as the o*er-the-
counter maret.
D. &he o*er-the-counter maret is ten times as big as the exchange-
traded maret.

Answer! D
 &he O&C maret is about ,3 trillion whereas the exchange-traded maret is
about ,3 trillion.

3. $hich of the following best describes the term =spot price>

A. &he price for immediate deli*ery
B. &he price for deli*ery at a future time
C. &he price of an asset that has been damaged
D. &he price of renting an asset

Answer! A
 &he spot price is the price for immediate deli*ery. &he futures or forward price
is the price for deli*ery in the future

?. $hich of the following is true about a long forward contract

A. &he contract becomes more *aluable as the price of the asset declines
B. &he contract becomes more *aluable as the price of the asset rises
 C. &he contract is worth <ero if the price of the asset declines after the
contract has been entered into
D. &he contract is worth <ero if the price of the asset rises after the
contract has been entered into

Answer! B
A long forward contract is an agreement to buy the asset at a predetermined
price. &he contract becomes more attracti*e as the maret price of the asset
rises. &he contract is only worth <ero when the predetermined price in the
forward contract e:uals the current forward price 6as it usually does at the
beginning of the contract8.

;. An in*estor sells a futures contract an asset when the futures price is ,1"2.
'ach contract is on 1 units of the asset. &he contract is closed out when
the futures price is ,1"2/. $hich of the following is true
A. &he in*estor has made a gain of ,/"
B. &he in*estor has made a loss of ,/"
C. &he in*estor has made a gain of ,#"
D. &he in*estor has made a loss of ,#"

Answer! B
An in*estor who buys 6has a long position8 has a gain when a futures price
increases. An in*estor who sells 6has a short position8 has a loss when a
futures price increases.

@. $hich of the following describes 'uropean options

A. 0old in 'urope
B. riced in 'uros
C. 'xercisable only at maturity
D. Calls 6there are no 'uropean puts8

Answer! C
'uropean options can be exercised only at maturity. &his is in contrast to
American options which can be exercised at any time. &he term ='uropean>
has nothing to do with geographical location" currencies" or whether the
option is a call or a put.

1.$hich of the following is %O& true

A. A call option gi*es the holder the right to buy an asset by a certain
date for a certain price
B. A put option gi*es the holder the right to sell an asset by a certain date
for a certain price
C. &he holder of a call or put option must exercise the right to sell or buy
an asset
D. &he holder of a forward contract is obligated to buy or sell an asset
 Answer! C
 &he holder of a call or put option has the right to exercise the option but is
not re:uired to do so. A" B" and C are correct

11.$hich of the following is %O& true about call and put options!
A. An American option can be exercised at any time during its life
B. A 'uropean option can only be exercised only on the maturity date
C. (n*estors must pay an upfront price 6the option premium8 for an option
contract
D. &he price of a call option increases as the strie price increases

Answer! D
A call option is the option to buy for the strie price. As the strie price
increases this option becomes less attracti*e and is therefore less *aluable.
A" B" and C are true.

1#.&he price of a stoc on uly 1 is ,2?. A trader buys 1 call options on the
stoc with a strie price of ,3 when the option price is ,#. &he options are
exercised when the stoc price is ,32. &he trader’s net prot is
A. ,?
B. ,2
C. ,+
D. ,3

Answer! C
 &he payo4 from the options is 15632-38 or ,2. &he cost of the options is
#51 or ,#. &he net prot is therefore 27# or ,+.

1+.&he price of a stoc on ebruary 1 is ,1#/. A trader sells # put options on
the stoc with a strie price of ,1# when the option price is ,2. &he options
are exercised when the stoc price is ,11. &he trader’s net prot or loss is
A. Eain of ,1"
B. Foss of ,#"
C. Foss of ,#";
D. Foss of ,1"

Answer! D
 &he payo4 that must be made on the options is #561#7118 or ,#.
 &he amount recei*ed for the options is 25# or ,1. &he net loss is
therefore #71 or ,1.

1/.&he price of a stoc on ebruary 1 is ,;/. A trader buys # put options on
the stoc with a strie price of ,@ when the option price is ,1. &he options
are exercised when the stoc price is ,;2. &he trader’s net prot or loss is
A. Foss of ,1"
 B. Foss of ,#"
C. Eain of ,#
D. Eain of ,1

Answer! A
 &he payo4 is @7;2 or ,2 per option. or # options the payo4 is therefore
25# or ,1. Gowe*er the options cost 15# or ,#. &here is
therefore a net loss of ,1.

12.&he price of a stoc on ebruary 1 is ,/;. A trader sells # put options on
the stoc with a strie price of ,/ when the option price is ,#. &he options
are exercised when the stoc price is ,+@. &he trader’s net prot or loss is
A. Foss of ,;
B. Foss of ,#
C. Eain of ,#
D. Foss of ,@

Answer! C
 &he payo4 is /7+@ or ,1 per option. or # options the payo4 is therefore
15# or ,#. Gowe*er the premium recei*ed by the trader is #5# or
,/. &he trader therefore has a net gain of ,#.

13.A speculator can choose between buying 1 shares of a stoc for ,/ per
share and buying 1 'uropean call options on the stoc with a strie price
of ,/2 for ,/ per option. or second alternati*e to gi*e a better outcome at
the option maturity" the stoc price must be abo*e
A. ,/2
B. ,/3
C. ,22
D. ,2

Answer! D
$hen the stoc price is ,2 the rst alternati*e leads to a position in the stoc
worth 152 or ,2. &he second alternati*e leads to a payo4 from the
options of 15627/28 or ,2. Both alternati*es cost ,/. (t follows that
the alternati*es are e:ually protable when the stoc price is ,2. or stoc
prices abo*e ,2 the option alternati*e is more protable.

1?.A company nows it will ha*e to pay a certain amount of a foreign currency
to one of its suppliers in the future. $hich of the following is true
A. A forward contract can be used to loc in the exchange rate
B. A forward contract will always gi*e a better outcome than an option
C. An option will always gi*e a better outcome than a forward contract
D. An option can be used to loc in the exchange rate

Answer! A
A forward contract ensures that the e4ecti*e exchange rate will e:ual the
current forward exchange rate. An option pro*ides insurance that the
exchange rate will not be worse than a certain le*el" but re:uires an upfront
 premium. Options sometimes gi*e a better outcome and sometimes gi*e a
worse outcome than forwards.

1;.A short forward contract on an asset plus a long position in a 'uropean call
option on the asset with a strie price e:ual to the forward price is e:ui*alent
to
A. A short position in a call option
B. A short position in a put option
C. A long position in a put option
D. %one of the abo*e

Answer! C
0uppose that 0 & is the nal asset price and H is the strie priceIforward price.
A short forward contract leads to a payo4 of H70 &. A long position in a
'uropean call option leads to a payo4 of max60 &7H" 8. $hen added together
we see that the total position leads to a payo4 of max6" H70 &8" which is the
payo4 from a long position in a put option. C can also be seen to be true by
plotting the payo4s as a function of the nal stoc price.

1@.A trader has a portfolio worth ,2 million that mirrors the performance of a
stoc index. &he stoc index is currently 1"#2. utures contracts trade on the
index with one contract being on #2 times the index. &o remo*e maret ris
from the portfolio the trader should
A. Buy 13 contracts
B. 0ell 13 contracts
C. Buy # contracts
D. 0ell # contracts

Answer! B
One futures contract protects a portfolio worth 1#25#2. &he number of
contract re:uired is therefore 2""I61#25#28J13. &o remo*e maret
ris we need to gain on the contracts when the maret declines. A short
futures position is therefore re:uired.

#.$hich of the following best describes a central clearing party

A. (t is a trader that wors for an exchange
B. (t stands between two parties in the o*er-the-counter maret
C. (t is a trader that wors for a ban
D. (t helps facilitate futures trades

Answer! B

A central clearing party 6CC8 is a clearing house that stands between two
parties in the o*er-the-counter maret. (t ser*es the same purpose as an
exchange clearing house.