Level I Derivative Markets and
Instruments
Test Code: L1 R56 DVMI Q-Bank
Number of questions: 56
Question
1
Q-Code: L1-DV-DVMI-001
LOS a
Section 2
Which of the following is not a derivative?
A) A contract to purchase shares of Infosys, a technology company, at a fixed price.
B) An asset backed security.
C) A global equity mutual fund.
Answer
C) A global equity mutual fund.
Explanation C is correct. A derivative is a financial instrument which derives its value from the performance of an underlying
(asset). In simple terms, a derivative is a legal contract between a buyer and a seller entered into today, regarding a
transaction that will be fulfilled at a specified time in the future. For example, a contract to purchase the shares of
XYZ Company at $50 after six months is an example of a derivative contract.
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims
are issued on the portfolio in the form of tranches, such that the prepayments or credit losses are allocated to the
most-junior tranches first and the most-senior tranches last.
Another definition of a derivative is that it is a financial instrument that transforms the performance of the
underlying. Mutual funds do not transform the value of a payoff of an underlying asset; they merely pass those
payoffs through to their holders. Hence, they are not derivatives. Section 2. LO.a.
Question
2
Q-Code: L1-DV-DVMI-002
LOS a
Section 2
Which of the following statements is most likely to be correct about derivatives?
A) A derivative is a financial instrument that derives its value based on the performance of the underlying.
B) Derivatives are standardized financial instruments and cannot be customized.
C) The performance of a derivative is derived by replicating the performance of the underlying.
Answer
A) A derivative is a financial instrument that derives its value based on the performance of the underlying.
Explanation A is correct. A derivative is a financial instrument that derives its value based on the performance of the underlying
(asset).
B is incorrect because unlike an exchange-traded derivative, over-the-counter contracts are customized as per
client’s needs.
C is incorrect because the performance of a derivative is derived by transforming, and not by replicating the
performance of the underlying. Section 2 and 3. LO.a.
Question
3
Q-Code: L1-DV-DVMI-003
LOS a
Section 2
Which of the following statements about derivatives is least accurate?
A) They derive their value from an underlying.
B) They have low degrees of leverage.
C) They involve two parties – a buyer and a seller.
Answer
B) They have low degrees of leverage.
Explanation B is correct. Derivatives have high degrees of leverage. A and C are accurate statements. A derivative is a financial
instrument which derives its value from the performance of an underlying (asset). In simple terms, a derivative is a
legal contract between a buyer and a seller entered into today, regarding a transaction that will be fulfilled at a
specified time in the future. Section 2. LO.a.
Question
Q-Code: L1-DV-DVMI-004
LOS a
Section 2
4
Which of the following statements about derivatives is not true?
A) They are used for risk management.
B) They are created in the form of legal contracts.
C) They are created in the spot market.
Answer
C) They are created in the spot market.
Explanation C is correct. Derivatives are not created in the spot market, which is where the underlying trades. Other two
statements are true. Derivatives are a cost-effective way of transferring risk from one party to another. For
example, if an investor has a substantial investment in a stock that he does not want to sell, but reduce the risk, he
can do so by taking a short position in a futures contract or buying a put option.
A derivative is a legal contract between a buyer and seller entered into today, regarding a transaction that will be
fulfilled at a specified time in the future. Section 2 and 5. LO.a.
Question
5
Q-Code: L1-DV-DVMI-005
LOS a
Section 3
Which of the following statements about exchange-traded derivatives is least accurate?
A) They are more transparent than over-the-counter derivatives.
B) All terms of the contract except the price are standardized.
C) They have more credit risk than over-the-counter derivatives.
Answer
C) They have more credit risk than over-the-counter derivatives.
Explanation C is correct. Exchange-traded contracts have less credit risk than OTC derivatives because of the presence of a
clearinghouse, which guarantees that the winning party gets paid by requiring participants to post a margin (cash
deposit) called margin or performance bonds, and uses these deposits to make a payment in the event of default.
Statement A is correct as the presence of a clearinghouse also makes the whole process transparent. All the
information regarding prices, settlement, daily turnover is disclosed within exchanges and clearinghouse which
means there is a lack of privacy and flexibility.
Statement B is correct as the exchange-traded derivative clearly specifies when it can be traded, when it will expire,
what is the lot size, a minimum amount, and settlement price. There is no room for customization. The only aspect
not defined is the price. The price is determined by the buyers and sellers. For example, a gold contract on CME
defines its quality (995 fineness), contract size (100 troy ounces), how it will be settled (physical) and so on. Section
3.1 and 3.2. LO.a.
Question
6
Q-Code: L1-DV-DVMI-007
LOS a
Section 3
Which of the following best describes a characteristic of exchange-traded derivatives?
A) They are customized financial instruments.
B) A clearing house effectively guarantees against default risk.
C) They are characterized by a low degree of regulation.
Answer
B) A clearing house effectively guarantees against default risk.
Explanation B is correct. Exchange-traded derivatives are guaranteed by a clearing house against default.
A is incorrect because the exchange traded derivatives are standardized. To standardize a derivative implies that
the contract is bound by terms and conditions, and there is little ability to alter those terms.
C is incorrect because they are characterized by a high degree of regulation. Section 3.1 and 3.2. LO.a.
Question
7
Q-Code: L1-DV-DVMI-008
LOS a
Section 3
Which of the following statements about over-the-counter derivatives is least accurate ?
A) They are less liquid than exchange-traded derivatives.
B) They are less regulated than exchange-traded derivatives.
C) They offer more flexibility than exchange-traded derivatives.
Answer
A) They are less liquid than exchange-traded derivatives.
Explanation A is correct. Because of the customization and flexibility of OTC derivatives, there is a tendency to think that the
OTC market is less liquid than the exchange market. However, this is not necessarily true. Many OTC instruments
can easily be created and then essentially offset by doing the exact opposite transaction, often with the same
party.
Statement C is accurate. OTC contracts are negotiated directly between two parties without an exchange. Hence,
they are less regulated. Section 3.1 and 3.2. LO.a.
Question
8
Q-Code: L1-DV-DVMI-037
LOS c
Section 3
One way to describe the margin in a futures market is:
A) A good faith deposit that covers possible future losses.
B) A loan to the futures trader.
C) The difference between the futures price and the spot price.
Answer
A) A good faith deposit that covers possible future losses.
Explanation A is correct. The initial margin can be thought of as a good faith deposit or performance bond. It covers possible
future losses. Section 3.1. LO.c.
Question
9
Q-Code: L1-DV-DVMI-006
LOS a
Section 3
Which of the following least likely describes over-the-counter (OTC) derivatives relative to exchange-traded
derivatives? OTC derivatives are:
A) more customized.
B) less liquid.
C) less transparent.
Answer
B) less liquid.
Explanation B is correct. There is a tendency to think that OTC market is less liquid relative to the exchange market, but this is
not necessarily true. Other two statements are correct. Unlike an exchange-traded derivative, OTC contracts are
customized as per the client’s needs and are negotiated directly between two parties without an exchange, making
them less transparent. Section 3.1 and 3.2. LO.a.
Question
10
Q-Code: L1-DV-DVMI-009
LOS a
Section 3
Analyst 1: Market makers earn a profit in both exchange and over-the-counter derivatives markets by charging a
commission on each trade.
Analyst 2: Market makers earn a profit in both exchange and over-the-counter derivatives markets by buying at
one price, selling at a higher price, and hedging any risk.
Which analyst’s statement is most likely correct?
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer
B) Analyst 2.
Explanation B is correct. Market makers can operate in both exchange-traded and OTC markets. The market makers make
money through the bid-ask spread. For instance, if party A wants to take a long position, the market maker will take
the opposite position, i.e. a short position. The market maker will then look for another party, suppose B, with
whom the market maker will take a long position. In other words, the market maker will sell to party A and buy from
party B. The overall effect is cancelled out, and no matter what happens to the underlying, the market maker is
covered. The bid amount will be lesser than the ask price, and the difference between both will generate a profit for
the market maker.
They do not charge a commission. Section 3.2. LO.a.
Question
11
Q-Code: L1-DV-DVMI-010
LOS a
As compared to exchange-traded derivatives, over-the-counter derivatives are more likely to have:
A) lower credit risk.
Section 3
B) customized contract terms.
C) lower risk management uses.
Answer
B) customized contract terms.
Explanation B is correct. Customization of contract terms is a characteristic of over-the-counter derivatives.
Unlike an exchange-traded system where the clearinghouse guarantees settlement, OTC derivatives have credit
risk. Each party bears the risk that the other party will default. Both exchange-traded derivatives and over-thecounter derivatives have same risk management uses. Section 3.2 and 5. LO.a.
Question
12
Q-Code: L1-DV-DVMI-011
LOS a
Section 4
As compared to over-the-counter options, futures contract:
A) are private, customized transactions.
B) represent a right rather than a commitment.
C) are not exposed to default risk.
Answer
C) are not exposed to default risk.
Explanation C is correct. A futures contract is a standardized derivative contract created and traded on a futures exchange
such as Chicago Mercantile Exchange (CME). Hence, these contracts are standardized and are not exposed to
default risk.
A forward commitment is a contract that requires both parties to engage in a transaction at a later point in time
(the expiration) on terms agreed upon today. It includes forward contracts, futures contracts and swaps. Another
category of derivative instruments is called contingent claims. The holder of a contingent claim has the right, but
not the obligation to make a final payment contingent on the performance of the underlying.
In a contingent claim, two parties, A and B, sign a contract at time 0 to engage in a transaction at time T. Unlike a
forward or futures contract, A has the right, but not the obligation to make a payment and take delivery of the
asset at time T. Section 4.1 and 4.2. LO.a.
Question
13
Q-Code: L1-DV-DVMI-015
LOS b
Section 4
Which of the following is best classified as a forward commitment?
A) A convertible bond.
B) A swap agreement.
C) An asset-backed security.
Answer
B) A swap agreement.
Explanation B is correct. A swap agreement is equivalent to a series of forward agreements, which are described as forward
commitments. Forward commitments are contracts entered into at one point in time that require both parties to
engage in a transaction at a later point in time (the expiration), on terms agreed upon at the start. Examples:
forward contracts, futures contracts and swaps.
On the other hand, convertible bonds and asset-backed securities are classified as contingent claims. The holder of
a contingent claim has the right, but not the obligation, to make a final payment, contingent on the performance of
the underlying.
A is incorrect because the convertible bond is an example of hybrid instrument which is created by combining
bonds and options. Section 4, 4.1 and 4.2. LO.b.
Question
14
Q-Code: L1-DV-DVMI-016
LOS c
Section 4
Which of the following statements about futures is least accurate?
A) They are standardized.
B) They are subject to daily price limits.
C) Their payoffs are received at settlement.
Answer
C) Their payoffs are received at settlement.
Explanation C is correct. Any payoffs in the future contracts are settled on daily basis by the exchange through its
clearinghouse. This process is called mark to market.Other two statement are true. Futures contracts are
standardized derivative contracts and are subject to daily price limits. Section 4.1. LO.c.
Question
15
Q-Code: L1-DV-DVMI-017
LOS c
Section 4
Which of the following statements is most accurate?
A) Forwards are customized whereas swaps are standardized.
B) Forwards are subject to daily price limits whereas swaps are not.
C) Swaps have multiple payments, whereas forwards have only a single payment.
Answer
C) Swaps have multiple payments, whereas forwards have only a single payment.
Explanation C is correct. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment,
made at its expiration date.
A is incorrect because both forwards and swaps are standardized derivative contracts.
B is incorrect because neither forwards nor swaps are subject to daily price limits. Only futures contracts are
subject to daily price limits. Section 4.1. LO.c.
Question
16
Q-Code: L1-DV-DVMI-018
LOS c
Section 4
Analyst 1: During daily settlement of futures contract the initial margin deposits are refunded to the two parties.
Analyst 2: During daily settlement of futures contract losses are charged to one party and gains credited to the
other.
Which analyst’s statement is most likely correct ?
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer
B) Analyst 2.
Explanation B is correct. During daily settlement losses and gains are collected and distributed to the respective parties through
a process called mark to market. Option A is incorrect because during daily settlement of futures contract the initial
margin deposits are not refunded to any party. Section 4.1. LO.c.
Question
17
Q-Code: L1-DV-DVMI-023
LOS c
Section 4
While dealing with futures contracts, the maintenance margin requirement most likely refers to:
A) collateral to ensure fulfillment of obligation.
B) amount sufficient to bring ending account balance back to initial margin.
C) the minimum account balance a trader must maintain after the trade is initiated.
Answer
C) the minimum account balance a trader must maintain after the trade is initiated.
Explanation C is correct. Futures position holders are required to maintain a minimum level of account balance which is called
the maintenance margin requirement. The amount sufficient to bring ending account balance back to initial margin
requirement is called the variation margin. Initial margin is the collateral or performance bond that ensures the
fulfillment of the obligation. Section 4.1. LO.c.
Question
18
Q-Code: L1-DV-DVMI-024
LOS c
Section 4
In which of the following contracts would the buyer face the least default risk?
A) Cotton futures.
B) Currency forwards.
C) Over-the-counter interest rate options.
Answer
A) Cotton futures.
Explanation A is correct. While forward contracts and over-the-counter options are customized private contracts between
parties with a presence of default risk, futures contracts have the least risk of default because of the presence of a
clearinghouse as an intermediary guaranteeing the parties against default through the practice of daily settlement.
Section 3.2, 4.1 and 4.2. LO.c.
Question
19
Q-Code: L1-DV-DVMI-025
LOS c
Section 4
Microsoft issues 10-year fixed-rate bonds. Its treasurer expects interest rates to increase for all maturities for at
least the next 2 years. He enters into a 2-year agreement with SCB to receive semi-annual floating-rates payments
benchmarked on 6-month LIBOR and to make payments based on a fixed-rate. This agreement is best described
as a:
A) Swap.
B) Futures contract.
C) Forward contract.
Answer
A) Swap.
Explanation A is correct. A swap is an agreement between two parties to exchange a series of future cash flows. Microsoft
receives floating interest rate payments and makes fixed interest rate payments. The given agreement is a swap.
Other two options are incorrect because in both forward and futures contracts, two parties agree to exchange a
specific quantity of the underlying asset at an agreed-upon price at a later date. The buyer agrees to purchase the
underlying asset from the other party, the seller. Section 4.1. LO.c.
Question
20
Q-Code: L1-DV-DVMI-026
LOS c
Section 4
Ali takes a long position in 50 futures contracts on Day 1. The futures have a daily price limit of €10 and closes with
a settlement price of €105. On Day 2, the futures trade at €115 and the bid and offer move to €116 and €118,
respectively. The futures price remains at these price levels until the market closes. The marked-to-market amount
the trader receives in his account at the end of Day 2 is closest to:
A) €500.
B) €550.
C) €650.
Answer
A) €500.
Explanation A is correct. Because the future has a daily price limit of €10, the highest possible settlement price on Day 2 is
€115. Therefore, the marked to market value would be (€115 - €105) * 50 = €500. Section 4.1. LO.c.
Question
21
Q-Code: L1-DV-DVMI-028
LOS c
Section 4
Keene Smith, an investor, aims to invest in derivatives that can be classified as forward commitments. Which of the
following is she least likely to consider?
A) Credit default swaps.
B) Futures contracts.
C) Interest rate swaps.
Answer
A) Credit default swaps.
Explanation A is correct. A credit default swap (CDS) is a derivative in which the seller provides credit protection to the buyer
against the credit risk of a separate party. It is hence classified as a contingent claim.
B and C are incorrect because futures contracts and interest rate swaps are classified as forward commitments.
Section 4.1 and 4.2. LO.c.
Question
22
Q-Code: L1-DV-DVMI-029
LOS c
Section 4
Which of the following is most likely to be correct regarding interest rate swaps?
A) Interest rate swaps provide the right to buy or sell the underlying asset in the future.
B) Interest rate swaps provide the promise to provide credit protection in the event of a default.
C) Interest rate swaps involve the obligation to lend or borrow at a given rate in the future at a fixed rate.
Answer
C) Interest rate swaps involve the obligation to lend or borrow at a given rate in the future at a fixed rate.
Explanation C is correct. A swap is an over-the-counter contract between two parties to exchange a series of cash flows based
on some pre-determined formula. The simplest swap is a plain vanilla interest rate swap. Interest rate swaps are
forward commitments that require one party to pay a fixed rate and the other party to pay floating rate during the
life of the swap.
A and B are incorrect because they are characteristics of credit default swaps. A credit default swap is a derivative
contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a
series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the
default of a third party. Section 4.1. LO.c.
Question
23
Q-Code: L1-DV-DVMI-055
LOS c
Section 6
An attribute common to both forward and futures contracts is:
A) their mark to market feature.
B) their standardized nature.
C) their use in hedging and speculation.
Answer
C) their use in hedging and speculation.
Explanation C is correct. Both forward and futures contracts are used for hedging and speculation purposes. Futures are
marked to market every day and are standardized, whereas forward contracts are customized and are settled at
expiry (there is no mark-to-market in between). Section 4.1 and 6.1. LO.c.
Question
24
Q-Code: L1-DV-DVMI-031
LOS c
Section 4
Which of the following statements is least likely correct about interest rate swaps ?
A) Interest rate swaps are derivatives where two parties agree to exchange a series of cash flows.
B) Interest rate swaps might require one party to make payments based on a fixed rate.
C) Interest rate swaps give the buyer the right to purchase the underlying from the seller.
Answer
C) Interest rate swaps give the buyer the right to purchase the underlying from the seller.
Explanation C is correct. Interest rate swaps are derivatives where two parties agree to exchange a series of cash flows.
Typically, one set of cash flows is variable and the other set is fixed. Option C is a true statement with respect to
call options, not swaps. Section 4.1 and 4.2. LO.c
Question
25
Q-Code: L1-DV-DVMI-036
LOS c
Section 4
Joe is a futures trader. If on a given day his balance falls below the maintenance margin, he should add funds so as
to meet the:
A) Initial margin.
B) Maintenance margin.
C) Variation margin.
Answer
A) Initial margin.
Explanation A is correct. In the futures markets the investor must top up to the initial margin. In the stock market an investor
only needs to top up to the maintenance margin.
Variation margin is the additional margin that must be deposited in an amount sufficient to bring the balance up to
the initial margin requirement. Maintenance margin is the minimum amount that is required by a futures
clearinghouse to maintain a margin account and to protect against default. Participants whose margin balances
drop below the required maintenance margin must replenish their accounts. Section 4.1. LO.c.
Question
26
Q-Code: L1-DV-DVMI-035
LOS c
Section 4
Which of the following statements is most accurate?
A) A forward contract is default free, whereas a futures contract is not.
B) A forward contact allows parties to enter into a customized transaction, whereas a futures contract does not.
C) A forward contract can easily be offset prior to expiration, whereas it is difficult to offset a futures contract prior
to expiration.
Answer
B) A forward contact allows parties to enter into a customized transaction, whereas a futures contract does not.
Explanation B is correct. Unlike futures contracts, which have standardized features, forward contracts can be customized to
suit the needs of the parties involved.
Futures are exchange traded contracts with a credit guarantee and a protection against default. Forwards, on the
other hand, are over-the-counter contracts that are privately negotiated and are subject to default. Therefore, A is
incorrect.
Futures contracts can easily be offset prior to expiration as they are standardized in nature, making it easy to take
an opposite position. Whereas, it is difficult to offset forward contracts prior to expiration because they are
customized in nature, making it difficult to find a counterparty. Section 3.2 and 4.1. LO.c.
Question
27
Q-Code: L1-DV-DVMI-032
LOS c
Section 4
Which of the following is least likely to be subject to default?
A) Forwards.
B) Futures.
C) Interest rate swaps.
Answer
B) Futures.
Explanation B is correct. Futures are exchange traded contracts with a credit guarantee and a protection against default.
Interest rate swaps and forwards are over-the-counter contracts that are privately negotiated and are subject to
default. Section 3.2 and 4.1. LO.c.
Question
28
Q-Code: L1-DV-DVMI-033
LOS c
Section 4
Klaus, Veronica, and Liam deal in derivatives. Liam and Veronica have a value of zero at the initiation of the contract,
while Klaus doesn’t. Which of the following correctly describes the derivative that each of these are dealing in?
Klaus
Veronica
Liam
A.
Futures
Options
Forwards
B.
Forwards
Futures
Options
C.
Options
Forwards
Futures
A) Option A in the above table.
B) Option B in the above table.
C) Option C in the above table.
Answer
C) Option C in the above table.
Explanation C is correct. Options require the payment of an option premium to the seller of the option at the initiation of the
contract. The premium can be thought of as the value of the option contract.
Futures and forwards have a value of zero at the initiation of the contract. Futures contracts do require an initial
deposit (initial margin) but this can be thought of as a down payment or a performance bond. The initial margin
does not represent the value of the futures contract. Section 4.1 and 4.2. LO.c.
Question
29
Q-Code: L1-DV-DVMI-012
LOS b
Section 4
Which of the following statements is least accurate?
A) An asset backed security is a contingent claim.
B) An interest rate swap is a forward commitment.
C) A credit default swap is a forward commitment.
Answer
C) A credit default swap is a forward commitment.
Explanation C is correct. A credit default swap is a type of contingent claims. The holder of a contingent claim has the right, but
not the obligation to make a final payment contingent on the performance of the underlying.
An asset backed security is a type of a forward commitment. A forward commitment is a contract that requires
both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon today. The
parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or
settled when it expires, and the fixed price at which the underlying will be exchanged. Both the parties – the buyer
and the seller - have an obligation to engage in the transaction at a future date in a forward commitment. An
interest rate swap is also a type of forward commitment.
Question
30
Q-Code: L1-DV-DVMI-030
LOS c
Section 4
Tim has a portfolio comprising of derivatives, which provide payoffs that are linearly related to the payoffs of the
underlying. Which of the following is least likely to be a part of Tim’s portfolio?
A) Forwards.
B) Interest-rate swaps.
C) Options.
Answer
C) Options.
Explanation C is correct. Options are contingent claims that provide a one-sided payoff. The payoffs of contingent claims are
not linearly related to the underlying, and only one party, the short, can default. A and B are incorrect as they are
types of forward commitments with a linear payoff. Section 4.2. LO.c.
Question
31
Q-Code: L1-DV-DVMI-013
LOS b
Section 4
Which of the following is not a forward commitment?
A) Futures contracts.
B) Interest rates swaps.
C) Asset backed securities.
Answer
C) Asset backed securities.
Explanation C is correct. Asset backed security is a type of Contingent claims.
Forward commitment includes forward contracts, futures contracts and swaps such as interest rate swaps.
Section 4, 4.1 and 4.2. LO.b.
Question
32
Q-Code: L1-DV-DVMI-014
LOS b
Section 4
Which of the following statements is least accurate about contingent claims?
A) The payoffs are not linearly related to the underlying.
B) The most the short can gain is the premium paid for the contingent claim.
C) Either party can default to the other.
Answer
C) Either party can default to the other.
Explanation C is correct. In contingent claims, only one party, the short, can default.
Because the option buyer (the long) does not have to exercise the option, beyond the initial payment of the
premium, there is no obligation of the long to the short. Thus, only the short can default, which would occur if the
long exercises the option and the short fails to do what it is supposed to do.
Forwards provide payoffs that are linearly related to the payoffs of the underlying. Whereas, the payoffs of options
are non-linear, for example a call option will provide a payoff only if the underlying crosses the strike price,
otherwise it will expire worthless and have a zero payoff. Therefore, A is incorrect.
B is incorrect because the maximum a short party can gain is the premium paid for the contingent claim. Section
4.2. LO.b.
Question
33
Q-Code: L1-DV-DVMI-019
LOS c
Which of the following statements about options is most accurate?
A) An option is the right to buy or the right to sell the underlying.
B) An option is the right to buy and sell, with the choice made at expiration.
C) An option is an obligation to buy or sell, which can be converted into the right to buy or sell.
Answer
A) An option is the right to buy or the right to sell the underlying.
Section 4
Explanation A is correct. An option is strictly the right to buy (a call) or the right to sell (a put). It does not provide both choices.
Similarly, the right to convert is an obligation, not a right. Therefore, statement C is incorrect.
Statement B is incorrect because American options can be exercised on or any time before the expiration date.
However, European options can only be exercised at expiration date. Section 4.2. LO.c.
Question
34
Q-Code: L1-DV-DVMI-020
LOS c
Section 4
Which of the following is a characteristic of a put option on the stock?
A) A guarantee that the stock price will decrease.
B) A specified date on which the right to sell expires.
C) A fixed price at which the put holder can buy the stock.
Answer
B) A specified date on which the right to sell expires.
Explanation B is correct. A put option on a stock provides no guarantee of any change in the stock price. It has an expiration
date on which the right to sell expires, and it has a fixed price at which the holder can exercise the option, thereby
selling the stock. Section 4.2. LO.c.
Question
35
Q-Code: L1-DV-DVMI-021
LOS c
Section 4
Analyst 1: A credit derivative is a derivative contract in which the seller provides protection to the buyer against the
credit risk of a third party.
Analyst 2: A credit derivative is a derivative contract in which the exchange provides a credit guarantee to both the
buyer and the seller.
Which analyst’s statement is most likely correct?
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer
A) Analyst 1.
Explanation A is correct. A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and
a credit protection seller, in which the latter provides protection to the former against a specific credit loss. B is
incorrect because in a credit derivative is a type of contingent claims where there is no involvement of an exchange.
Section 4.2. LO.c.
Question
36
Q-Code: L1-DV-DVMI-022
LOS c
Section 4
A corporation has issued 10-year, floating-rate bonds. The treasurer realizes that the interest rates are going to
rise and enters into an agreement to receive semi-annual payments based on the 6-month LIBOR and to make
semi-annual payments at a fixed rate. This agreement is best described as a(n):
A) option.
B) futures contract.
C) swap.
Answer
C) swap.
Explanation C is correct. It is a swap because two parties agree to exchange a series of cash flows in the future.
In a futures contract, two parties agree to exchange a specific quantity of the underlying asset at an agreed-upon
price at a later date. The buyer agrees to purchase the underlying asset from the other party, the seller. The
agreed-upon price is called the futures price.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller
or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific
expiration date or at any time prior to the expiration date. Section 4.1 and 4.2. LO.c.
Question
37
Q-Code: L1-DV-DVMI-027
LOS c
Section 4
A market participant has a view regarding the potential movement of a stock. He sells a customized over-thecounter put option on the stock when the stock is trading at USD46. The put has an exercise price of USD44 and
the put seller receives USD2.5 in premium. The price of the stock is USD43 at expiration. The profit or loss for the
put seller at expiration is:
A) USD(1.5).
B) USD1.5.
C) USD2.5.
Answer
B) USD1.5.
Explanation B is correct. Profit = max (0, premium – value of put at expiration) = max (0, premium-(X-S)) = 2.5 – 1 = 1.5.
Section 4.2. LO.c.
Question
38
Q-Code: L1-DV-DVMI-034
LOS c
Section 4
Which of the following accurately describes a credit derivative?
A) In a credit derivative, the seller provides the buyer with protection against credit risk of a third party.
B) At the initiation of the contract of a credit derivative, the buyer and seller provide a performance bond.
C) The buyer and seller of a credit derivative are provided with a credit guarantee by the clearinghouse.
Answer
A) In a credit derivative, the seller provides the buyer with protection against credit risk of a third party.
Explanation A is correct. A credit derivative is a derivative contract in which the seller provides credit protection to the buyer
against the credit risk of a third party.
B and C are incorrect because these are characteristics of futures, not credit derivatives. Section 4.1 and 4.2. LO.c.
Question
39
Q-Code: L1-DV-DVMI-053
LOS c
Section 4
Which of the following statements about the feature of an option is correct?​
A) Only the long party can default.
B) Only the short party can default.
C) Both long and short party can default.
Answer
B) Only the short party can default.
Explanation B is correct. There is always a possibility that short party may not fulfill its obligation if the long party decides to
exercise the option. Therefore, only the short party can default. Section 3.2 and 4.2. LO.c.
Question
40
Q-Code: L1-DV-DVMI-045
LOS d
Section 4
Analyst 1: Derivatives can be combined with other derivatives or underlying assets to form hybrids.
Analyst 2: Derivatives can be issued on weather, electricity, and disaster claims.
Which analyst’s statement is most likely correct?
A) Analyst 1.
B) Analyst 2.
C) Both.
Answer
C) Both.
Explanation C is correct. Derivatives can be combined with other derivatives or underlying assets to form hybrids. Derivatives
can be issued on a variety of such diverse underlying such as weather, electricity, and disaster claims. Section 4.3
and 4.4. LO.d.
Question
41
Q-Code: L1-DV-DVMI-038
Which of the following is an advantage of the derivatives market?
A) They are less volatile than spot markets.
B) They make it easier and less costly to transfer risk.
C) They incur higher transaction costs than spot markets.
Answer
B) They make it easier and less costly to transfer risk.
LOS d
Section 6
Explanation B is correct. Derivatives facilitate risk allocation by making it easier and less costly to transfer risk.
A is incorrect because derivatives are not necessarily more or less volatile than spot markets.
C is incorrect because derivatives incur lower transaction costs than spot markets. Section 5.1, 5.3 and 6.2. LO.d.
Question
42
Q-Code: L1-DV-DVMI-042
LOS d
Section 5
Sebastian is planning to invest in derivatives. Which of the following is least likely to be an advantage that he should
consider?
A) Effective risk management.
B) Greater opportunities to go short compared to the spot market.
C) Similar payoffs to those of underlying.
Answer
C) Similar payoffs to those of underlying.
Explanation C is correct. Derivative markets provide for effective risk management and thus result in payoffs different than
those of the underlying. Therefore similar payoffs are least likely to be an advantage to consider. An operational
advantage of derivative markets is the ease of going short in comparison to the underlying spot market. Section
5.1 and 5.3. LO.d.
Question
43
Q-Code: L1-DV-DVMI-056
LOS d
Section 5
When the implied volatility on equity market index options goes up, it is safe to assume that:
A) market interest rates have increased.
B) the market uncertainty has increased.
C) the market index value has increased.
Answer
B) the market uncertainty has increased.
Explanation B is correct. The implied volatility measures the risk of the underlying or the uncertainty associated with options. So
an increase in the implied volatility on equity market index options indicates that the market uncertainty has gone
up. Section 5.2. LO.d.
Question
44
Q-Code: L1-DV-DVMI-041
LOS d
Section 5
Which of the following is most likely to be greater for derivative markets compared to underlying spot markets?
A) Capital requirements.
B) Liquidity.
C) Transaction costs.
Answer
B) Liquidity.
Explanation B is correct. Derivative markets have greater liquidity than underlying spot markets with lower capital requirements
and lower transaction costs. Section 5.3. LO.d.
Question
45
Q-Code: L1-DV-DVMI-044
LOS d
Section 5
Compared to the underlying spot market, the derivatives market is least likely to have:
A) lower liquidity.
B) lower transaction costs.
C) lower capital requirements.
Answer
A) lower liquidity.
Explanation A is correct. Compared to the underlying spot market, the derivatives market has higher liquidity, lower transaction
costs and lower capital requirements. Section 5.3. LO.d.
Question
46
Q-Code: L1-DV-DVMI-052
Which of the following is most likely to be a criticism of the derivatives market?
A) Derivatives provide price information but only at a cost of increasing transaction costs.
LOS e
Section 6
B) Derivatives are highly speculative instruments and effectively permit legalized gambling.
C) Default risk exists within all instruments of the derivative market.
Answer
B) Derivatives are highly speculative instruments and effectively permit legalized gambling.
Explanation B is correct. The criticism to derivatives is that they are ‘too risky’ especially to investors with limited knowledge of
complicated instruments. Derivative markets do provide price information but also lower transaction costs.
Moreover, default risk is not existent in all instruments. With exchange traded instruments such as futures there is
virtually no default risk. Section 5.4 and 6.1. LO.e.
Question
47
Q-Code: L1-DV-DVMI-039
LOS d
Section 6
Which of the following statements about derivatives is least accurate?
A) Options convey the volatility of the underlying.
B) Swaps convey the price at which uncertainty in the underlying can be eliminated.
C) Futures convey the most widely used strategy of the underlying.
Answer
C) Futures convey the most widely used strategy of the underlying.
Explanation C is correct. Derivatives do not convey any information about the use of the underlying in strategies.
Statement A is true. It is possible to determine the implied volatility of the options through models such as BSM.
Statement B is accurate. Swaps convey the price at which uncertainty in the underlying can be eliminated. Section
6.2. LO.d.
Question
48
Q-Code: L1-DV-DVMI-040
LOS d
Section 6
While responding to criticism that derivatives can be destabilizing to the market, an analyst makes the following
statements:
Statement 1: Market crashes and panics have occurred since long before derivatives existed.
Statement 2: Derivatives are sufficiently regulated that they cannot destabilize the spot market.
Which statement is most likely correct?
A) Statement 1.
B) Statement 2.
C) Both.
Answer
A) Statement 1.
Explanation A is correct. Derivatives regulation is not more and is arguably less than spot market regulation. However, market
crashes and panics have a very long history, much longer than that of derivatives. Section 6.2. LO.d.
Question
49
Q-Code: L1-DV-DVMI-043
LOS d
Section 6
The benefits of derivatives can result in a destabilizing consequence. Which of the following is this most likely to be?
A) Arbitrage activities due to market price swings.
B) Asymmetric performance as a result of trading strategies created.
C) Defaults on the part of speculators and creditors.
Answer
C) Defaults on the part of speculators and creditors.
Explanation C is correct. The benefits of derivatives can result in excessive speculative trading and hence cause defaults on the
part of creditors and speculators. A is incorrect because arbitrage tends to bring about convergence of prices to
the intrinsic value. B is incorrect because asymmetric information is not itself destabilizing. Section 6.2. LO.d.
Question
50
Q-Code: L1-DV-DVMI-046
Arbitrage is often referred to as the:
A) law of one price.
B) law of similar prices.
C) law of limited profitability.
LOS e
Section 7
Answer
A) law of one price.
Explanation A is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a high price,
thereby earning a risk-free profit without committing any capital. The combined actions of arbitrageurs bring about
a convergence of prices. Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices.
There is nothing called the law of similar prices or the law of limited profitability. Section 7.2. LO.e.
Question
51
Q-Code: L1-DV-DVMI-047
LOS e
Section 7
When an arbitrage opportunity exists, the combined action of all arbitrageurs:
A) results in a locked-limit situation.
B) results in sustained profit to all.
C) forces the prices to converge.
Answer
C) forces the prices to converge.
Explanation C is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a high price,
thereby earning a risk-free profit without committing any capital. The combined actions of arbitrageurs bring about
a convergence of prices. Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices. Prices converge because of the heavy demand for the cheaper asset and the
heavy supply of the more expensive asset. Section 7.2. LO.e.
Question
52
Q-Code: L1-DV-DVMI-048
LOS e
Section 7
Analyst 1: An arbitrage is an opportunity to make a profit at no risk and with the investment of no capital.
Analyst 2: An arbitrage is an opportunity to earn a return in excess of the return appropriate for the risk assumed.
Which analyst’s statement is most likely correct?
A) Analyst 1.
B) Analyst 2.
C) Both.
Answer
A) Analyst 1.
Explanation A is correct. Arbitrage is risk free and requires no capital because selling the overpriced asset produces the funds
to buy the underpriced asset.
B is incorrect because arbitrage is the condition that if two equivalent assets or derivatives or combinations of
assets and derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a
high price, thereby earning a risk-free profit without committing any capital. Section 7.2. LO.e.
Question
53
Q-Code: L1-DV-DVMI-049
LOS e
Section 7
Which of the following statements about arbitrage is most accurate?
A) Arbitrage imposes penalty on rapid trading.
B) Arbitrage redistributes risk among market participants.
C) Arbitrage helps prices to converge to their relative fair values.
Answer
C) Arbitrage helps prices to converge to their relative fair values.
Explanation C is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a high price,
thereby earning a risk-free profit without committing any capital. The combined actions of arbitrageurs bring about
a convergence of prices. Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices. Arbitrage results in an acceleration of price convergence to fair values
relative to instruments with equivalent payoffs.
A is incorrect because arbitrage does not impose penalty on rapid trading.
B is incorrect because arbitrage does not redistribute risk among market participants. Section 7.2. LO.e.
Question
54
Q-Code: L1-DV-DVMI-050
LOS e
Section 7
David is studying the law of one price. Which of the following statements is most likely to be correct?
A) The law of one price explains that two assets producing equal future cash flows would sell for equal prices.
B) The law of one price describes how a risk-free profit can be earned without capital commitments.
C) The true fundamental value of the asset can be described by the law of one price.
Answer
A) The law of one price explains that two assets producing equal future cash flows would sell for equal prices.
Explanation A is correct. The law of one price occurs when participants in the market engage in arbitrage activities so that
identical assets sell for the same price in different markets. B refers to arbitrage and C does not account for
identical assets. Section 7.2. LO.e.
Question
55
Q-Code: L1-DV-DVMI-051
LOS e
Section 7
Which of the following most likely represents an arbitrage opportunity?
A) A risk free rate is earned by the combination of the underlying asset and a derivative.
B) Sale of the shares of a takeover target and purchase of shares of the potential acquirer.
C) Two identical assets or derivatives are sold for different prices in different markets.
Answer
C) Two identical assets or derivatives are sold for different prices in different markets.
Explanation C is correct. Arbitrage opportunities exist when the same asset or two equivalent assets, producing the same
result, sell for different prices. A and B are incorrect because they do not define arbitrage opportunities. Section
7.2. LO.e.
Question
56
Q-Code: L1-DV-DVMI-054
LOS e
Section 7
Which of the following characteristics is least likely needed for the existence of riskless arbitrage? The underlying
security:
A) can be short sold.
B) is relatively liquid.
C) is a financial asset.
Answer
C) is a financial asset.
Explanation C is correct. A riskless arbitrage can be done through both, financial asset and non-financial asset. A and B are
incorrect as derivatives are relatively liquid and can easily be short sold. Section 7.2. LO.e.