chp 6 - mock exam
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Questions and Answers

What is the purpose of hedging in investment management?

  • To speculate on asset prices
  • To diversify asset allocation
  • To reduce portfolio risk (correct)
  • To maximize portfolio risk
  • In derivative trading, what does OTC stand for?

  • Online Trading Consortium
  • Over-The-Counter (correct)
  • Open Trading Center
  • Organized Trading Channel
  • Which of the following is considered a financial asset?

  • Gold
  • Oil
  • Wheat
  • Bonds (correct)
  • Where do exchange-traded derivatives like those on the Chicago Mercantile Exchange (CME) take place?

    <p>On an organized exchange</p> Signup and view all the answers

    Which role do derivatives play in investment management besides hedging?

    <p>Anticipating future cash flows</p> Signup and view all the answers

    What is the purpose of using futures to fix the price of an asset before receiving a large cash inflow?

    <p>To hedge against the risk of prices decreasing before receiving the cash flow.</p> Signup and view all the answers

    How do derivatives such as futures help in making swift changes to the asset allocation of a fund?

    <p>By reducing the risk involved in implementing changes to the asset allocation.</p> Signup and view all the answers

    What is the primary goal of arbitrage in financial markets?

    <p>To take advantage of pricing anomalies between derivatives and underlying assets.</p> Signup and view all the answers

    When can a portfolio manager potentially profit from a pricing anomaly between a derivative and its underlying asset?

    <p>When the derivative is cheaper than its underlying asset.</p> Signup and view all the answers

    What distinguishes speculation from other investment strategies mentioned in the text?

    <p>Speculation requires assuming additional risk in pursuit of higher profits.</p> Signup and view all the answers

    What is the key distinguishing feature of a futures contract according to the text?

    <p>It is exchange-traded and dealt on standardized terms.</p> Signup and view all the answers

    In a futures contract, which party agrees to deliver the asset at a future date?

    <p>The seller</p> Signup and view all the answers

    Why might an electricity-generating company enter into a futures contract for crude oil according to the text?

    <p>To secure a fixed price for future oil purchases.</p> Signup and view all the answers

    What distinguishes a futures contract from an options contract?

    <p>Futures contracts obligate both parties to fulfill the transaction.</p> Signup and view all the answers

    For an oil company, what is a likely motivation to engage in a futures contract for oil production according to the text?

    <p>To guarantee future sales prices of their oil production.</p> Signup and view all the answers

    What does it mean when a market participant opens a trade?

    <p>Entering into a future contract as a buyer</p> Signup and view all the answers

    In the context of futures markets, what does 'going long' mean?

    <p>Committed to buying the underlying asset at the pre-agreed price</p> Signup and view all the answers

    What is the primary commitment of the person who is 'short' in a futures contract?

    <p>To deliver the underlying asset</p> Signup and view all the answers

    When a future is closed out without physical delivery, what term is used for this process?

    <p>Closing out the trade</p> Signup and view all the answers

    Which action distinguishes 'closing' in a futures contract from 'opening'?

    <p>Making a closing sale before the delivery date</p> Signup and view all the answers

    What happens if an opening buyer in a futures contract avoids delivery?

    <p>The buyer makes a closing sale</p> Signup and view all the answers

    What is the primary difference between being 'long' and being 'short' in futures trading?

    <p>Long positions are for buyers, while short positions are for sellers.</p> Signup and view all the answers

    What is typically done with physical assets underlying most futures?

    <p>They are closed out instead of being delivered.</p> Signup and view all the answers

    What motivates an opening buyer in a futures contract to make a closing sale before delivery?

    <p>To settle their position without physical delivery.</p> Signup and view all the answers

    What could happen if a market participant opens a trade and later decides to close it?

    <p>The trade will be settled without physical delivery.</p> Signup and view all the answers

    What is the key difference between an option and a future contract?

    <p>An option grants the right, but not the obligation, to buy or sell, whereas a future is a binding obligation.</p> Signup and view all the answers

    What distinguishes options traded on an exchange from those traded off-exchange in the OTC market?

    <p>OTC options are bespoke contracts, while exchange-traded options have standard sizes and terms.</p> Signup and view all the answers

    What characterizes the relationship between a buyer and seller in an option contract?

    <p>The buyer pays a premium to have the right, but not the obligation, to buy or sell from the seller.</p> Signup and view all the answers

    Why might investors choose to trade options in the OTC market instead of on an exchange?

    <p>Investors can customize contract terms in OTC options beyond standardized sizes and terms of exchange-traded options.</p> Signup and view all the answers

    What feature of options makes them attractive compared to futures contracts?

    <p>Options provide the right but not the obligation to buy or sell an asset.</p> Signup and view all the answers

    What term is used to describe the seller of a put option?

    <p>Writer</p> Signup and view all the answers

    In exchange-traded contracts, how do buyers and sellers settle the contract?

    <p>Through a clearing house that is part of the exchange</p> Signup and view all the answers

    What is the motivation for exchanges to match transactions between option holders and writers?

    <p>To avoid involvement in transactions between buyers and sellers</p> Signup and view all the answers

    What is the obligation of the seller when a buyer exercises a call option?

    <p>To deliver the asset at the exercise price</p> Signup and view all the answers

    Why do exchanges require a clearing house for settling option contracts?

    <p>To manage risks associated with delivery and exercise</p> Signup and view all the answers

    What is the key difference between a 'covered' and a 'naked' position in options trading?

    <p>Having the underlying asset vs. not having the underlying asset</p> Signup and view all the answers

    In the context of options contracts, what does the holder have the right to do?

    <p>Exercise the option to buy</p> Signup and view all the answers

    If an options writer has a 'naked' position, what does it imply?

    <p>The writer does not have the underlying asset</p> Signup and view all the answers

    What is the primary motivation for an investor to exercise an options contract?

    <p>Buy or sell shares at favorable prices</p> Signup and view all the answers

    Why does a writer of an options contract face unlimited theoretical losses in certain scenarios?

    <p>Lack of holding underlying assets to meet obligations</p> Signup and view all the answers

    What is the purpose of the two exchanges of cash flow known as the legs of the swap?

    <p>To allow one party to pay a fixed rate and the other party to receive a variable rate</p> Signup and view all the answers

    What is typically used as a benchmark rate for calculating variable interest rates in swaps?

    <p>LIBOR</p> Signup and view all the answers

    In the context of swaps, what role does the notional amount play?

    <p>It represents the amount borrowed by one party to fund a project</p> Signup and view all the answers

    How is the floating rate typically set in a swap agreement?

    <p>Benchmark rate plus a fixed percentage</p> Signup and view all the answers

    What term is used to describe the variable interest rate in swap agreements?

    <p>'Floating' rate</p> Signup and view all the answers

    What is the primary purpose of interest rate swaps mentioned in the text?

    <p>To insure against unexpected interest rate changes</p> Signup and view all the answers

    In an interest rate swap, what is meant by 'notional principal'?

    <p>The hypothetical amount used to calculate interest payments</p> Signup and view all the answers

    Why might a company with variable rate borrowing enter into an interest rate swap?

    <p>To hedge against potential losses from unfavorable interest rate changes</p> Signup and view all the answers

    What distinguishes an interest rate swap from a traditional loan?

    <p>Swaps involve the exchange of cash flows while loans do not</p> Signup and view all the answers

    How does entering into an interest rate swap benefit a company like Company A in the text?

    <p>By reducing the impact of interest rate fluctuations on project profitability</p> Signup and view all the answers

    What is the purpose of credit derivatives like a credit default swap (CDS)?

    <p>To provide insurance against adverse credit events.</p> Signup and view all the answers

    What determines the value of credit derivatives such as a credit default swap (CDS)?

    <p>Credit events related to a third-party company.</p> Signup and view all the answers

    How does a credit default swap (CDS) differ from traditional swap agreements?

    <p>In CDS, one party provides credit protection against credit events.</p> Signup and view all the answers

    Why might an organization choose to enter into a swap agreement?

    <p>To lock in a fixed interest rate and hedge against variable rates.</p> Signup and view all the answers

    Which financial concept best describes the function of the variable interest rate in a swap agreement?

    <p>Hedging</p> Signup and view all the answers

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