Derivatives: Problem Areas

An investor holds a short position in South American soybean futures. Which is the last day upon which the investor can close out their position?

A The day before the first notice day

B The last notice day

C The last trading day

D The day before the last trading day

The correct answer is: C - The last trading day

Explanation: The last day to close out a future position is the last trading day. Any positions still open after the last trading day will go to actual delivery. The long must close out their position the day before the first notice day to guarantee that they will not be forced to take delivery.

If the Bank of England lowers its base rate and the market rallies, which of the following portfolios will benefit most?

A Positive Delta, positive Rho

B Positive Delta, negative Rho

C Negative Delta, positive Rho

D Negative Delta, negative Rho

The correct answer is: B - Positive Delta, negative Rho

Explanation:

We want a portfolio that has a negative correlation with interest rates - i.e. the portfolio goes up when interest rates go down - and has a positive correlation with market prices -  i.e. the portfolio goes up when market prices go up.

This indicates a negative rho and positive delta.

Which of the following is responsible for publishing the 'list of deliverables' for a bond futures contract?

A The clearing house

B The exchange

C The debt issuer

D The central bank

The correct answer is: B - The exchange

Explanation: The exchange will publish the list of deliverable items.

SwapClear is the market’s longest-serving and only truly global interest rate swap clearing service. With unparalleled liquidity provided by over 100 members. To be a member an organisation must:

A be authorised by the Prudential Regulation Authority

B use Financial Information eXchange (FIX) protocols fully integrated

C contribute to LCH Group's default fund

D abide by the regulation of the International Organization of Securities Commissions (IOSCO)

The correct answer is: C - contribute to LCH Group's default fund

Explanation: To be a SwapClear clearing member (SCM), an organisation must: - be an LCH Group shareholder - contribute to LCH Group's default fund - meet minimum resource requirements - make regular financial reports to LCH Group, and - maintain adequate systems and records and employ operations staff with adequate expertise in swaps.

If short-term interest rates were expected to fall, what effect would this have on the spread between two delivery months on a futures contract with an underlying asset in good supply?

A Widen

B Narrow

C Remain unchanged

D Indeterminate

The correct answer is: B - Narrow

Explanation: The cost of carry would fall due to the lower interest rate, thus the difference between the two fair values would be narrower.

Which of the following situations would result in backwardation in cocoa futures?

A A weakening of basis

B A poor harvest reducing supply of cocoa

C High interest rates

D Strengthening of basis

The correct answer is: B - A poor harvest reducing supply of cocoa

Explanation: Backwardation is when near prices are higher than future prices. A poor harvest in cocoa would result in demand today rising to such an extent that near prices may rise higher than future prices.

Which of the following best represents the benefits of a covered short put position?

A Extra return in a stable market and some protection from a rising market

B Extra return in a stable market and some protection from a falling market

C Protection from a falling market at the expense of limited profits in a rising market

D Protection from a rising market at the expense of limited profits in a falling market

The correct answer is: A - Extra return in a stable market and some protection from a rising market

Explanation: A covered short put is a trade performed by an investor that requires an asset. They wish to buy the asset, but believe the return will be low, due to a static market. If the investor sells an OTM put on this, they generate extra income and defer the purchase of the asset. If the market remains static, this creates an extra income (premium on the option plus interest on what the investor would have spent on the asset). If the market rises a little, this strategy gives a little upside protection.

One of the main purposes of regulators is to reduce:-

A Operational risk

B Systemic risk

C Currency risk

D Capital risk

The correct answer is: B - Systemic risk

Explanation: The main purpose and aims of regulation, in all markets globally, are:-

To maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the securities and futures industry.
To promote understanding by the public of the operation and functioning of the securities and futures industry.
To provide protection for members of the public investing in or holding financial products.
To minimise crime and misconduct in the securities and futures industry.
To reduce systemic risks in the securities and futures industry.
To assist in maintaining the market's financial stability by taking appropriate steps in relation to the securities and futures industry.

An investor would like to purchase an option which gives them the right to buy or sell another option. Which would be a suitable choice?

A A bermudan option

B A compound option

C A chooser option

D A binary option

The correct answer is: B - A compound option

Explanation:

A bermudan option is an option (call or put) where early exercise is restricted to certain dates during its life.
A chooser option allows the holder to decide whether the option is a call or a put at a pre-determined time during it's life.
A binary option (also known as a digital option) pays a fixed amount, or nothing at all, depending
on the price of the underlying instrument at maturity.

Recent inflation data released in the UK has shown inflation has risen above the Monetary Policy Committe's upper limit. Which of the following would you expect to happen to the prices of gilts and other fixed income instruments (including Treasury bills)?

A Increase, Increase

B Increase, Decrease

C Decrease, Decrease

D Decrease, Increase

The correct answer is: C - Decrease, Decrease

Explanation: The MPC has a target of 2% with a 1% tolerance. Moving above the upper limit would suggest greater than 3%. There will therefore be an expectation that interest rates will increase to control inflation and therefore bond prices will decrease.

Which of the following is a characteristic of a block trade?

A Exchange will not provide a quotation of price

B Exchange will not provide a quotation of size

C The counterparty is able to choose a reasonable price

D Transactions can be completed without delay and with certainty of price and execution

The correct answer is: D - Transactions can be completed without delay and with certainty of price and execution

Explanation: A block trade is a large transaction made between an exchange member and a wholesale client. The exchange specifies the size of the transaction that is required before it becomes a block trade. Block trades are allowed to be negotiated away from the central order book as long as they are reported into the exchange once they are agreed.

To secure exemption under CFTC Part 30, FCA members must do all of the following except:

A Join the NFA arbitration scheme

B Pay funds, the amount calculated in accordance with the size and business of the firm, into an escrow account at the NFA to cover any potential legal liabilities

C Provide the CFTC via the FCA with any relevant client records

D Send and receive back from clients the generic CFTC risk disclosures

The correct answer is: B - Pay funds, the amount calculated in accordance with the size and business of the firm, into an escrow account at the NFA to cover any potential legal liabilities

Explanation: CFTC Part 30 is explained in full in the Chapter Regulatory Requirements.

Paul buys a bond for £100 which subsequently rises to £105. He then sells a call option for a premium of £1 and a strike price of £105 as he does not think the price will rise any further. If the bond's price actually rises to £107 what percentage return does Paul make?

A 4%

B 5%

C 6%

D 7%

The correct answer is: C - 6%

Explanation:

If the bond trades at £107 the call option will be exercised against the writer (Paul).
Profit on bond delivered through option = £105 - £100 = £5
Premium received = £1
Return = £6 / £99 = 0.0606 or 6.06%
Note: the £99 is the net investment: the price of the bond minus the premium received.

Which of the following is an advantage of pooled funds?

A Dilution levy

B No charges

C Geographical diversification

D Investor has direct control over their investment

The correct answer is: C - Geographical diversification

Explanation: Pooled funds are small collective schemes. An advantage is that the small investor may achieve diversification reasonably cheaply. Dilution levy is charge to an investor when they redeem many units or shares.

If the long end of the euro curve is expected to flatten what would a trader do?

A Sell euribor futures and buy bund futures

B Buy euribor futures and sell bund futures

C Buy euribor futures and buy bund futures

D Sell euribor futures and sell bund futures

The correct answer is: A - Sell euribor futures and buy bund futures

Explanation: The expectation is that short term euro interest rates (like euribor) are expected to rise and longer term rates are expected to fall.

The holder of a preference share would not:

A Usually receive a fixed dividend.

B Have priority over ordinary shares in the event of liquidation

C Have pre-emption rights

D Have both cumulative and participating rights.

The correct answer is: C - Have pre-emption rights

Explanation: Preference shares do not have pre-emption rights all the others are true.

Which of the following deliverables is the cheapest-to-deliver?

• 8% Treasury with an implied repo rate of 6.7%.

• 8.5% Treasury with an implied repo rate of 6.3%.

• 6% Exchequer with an implied repo rate of 6.9%.

• 6.5% Treasury with an implied repo rate of 6.4%.

A 6.5% Treasury

B 8.5% Treasury

C 6% Exchequer

D 8% Treasury

The correct answer is: C - 6% Exchequer

Explanation: The cheapest-to-deliver is the gilt with the HIGHEST implied repo rate.

Which of the following best describes the purpose of the FCA's push towards Treating Customers Fairly (TCF)?

A An agenda that led to the creation of MiFID and has been replaced by the rules in this directive

B An agenda that helps consumers achieve a fair deal in the retail market

C A set of principles set down for all FCA regulated firms to follow

D A set of principles providing guidance to firms conducting eligible counterparty business

The correct answer is: B - An agenda that helps consumers achieve a fair deal in the retail market

Explanation:

TCF does consist of principles, but the principles only apply to firms conducting retail business.
Choice 'B' is the best of the descriptions given.

Which of the following is NOT a possible consequence of inadequate monitoring of an open derivatives position?

A New cash positions may be established

B Unexpected cash calls to meet variation margin

C Unexpected cash calls to meet initial margin

D Position closed-out by another counterparty

The correct answer is: D - Position closed-out by another counterparty

Explanation:

If a position is not monitored, the investor will not be aware if the positions are about to reach delivery. This could lead to a position in the cash market, or unexpected calls to meet margin.

Which of the following trades on exchange primarily as a principal?

A Broker acting as an agent

B Private investor

C Broker acting for client

D Market maker

The correct answer is: D - Market maker

Explanation:

Market makers and private investors both trade as principals, however only the market maker will be dealing directly on exchange.

The popularity of OTC derivatives trading has increased because of:

A Liquidity in the OTC market

B Protection afforded by stringent regulation

C Diversity due to flexibility over contract specifications

D Strict margin requirements guaranteeing against default

The correct answer is: C - Diversity due to flexibility over contract specifications

Explanation: OTC markets are not liquid, with bespoke contracts being designed to the specifications of market participants. There is less stringent regulation and generally no requirement for margin.

If forward rates are due to flatten the yield curves would become more:-

A Normal

B Upward

C Inverted

D Horizontal

The correct answer is: D - Horizontal

Explanation: A flattening of the yield curve would make it more horizontal.