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Equity Derivatives (Series VIII): 33 practice questions with answers

Our own questions on the subjects of this examination, under 6 topic headings. Try each before opening its answer.

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How to use this page

Read a question, choose your answer, and only then open "Show the answer". Each answer has a line of explanation; if it surprises you, find the topic in NISM's workbook and read that part again. The questions are written by us in the four kinds a multiple choice paper uses: definitions, roles, rules of principle and calculations. They are not NISM's questions and the real paper will word things differently, so learn the idea, not the sentence. We have left out figures that the regulator or the exchanges revise, such as tax rates, limits, timings and margins: take those from the current workbook. The real paper has 100 questions in 120 minutes with a pass mark of 60%; a wrong answer costs 25% of the marks of the question.

The questions

Basics of derivatives

1. A derivative is a contract whose value depends on

  1. the face value of a share
  2. the credit rating of the broker
  3. the profit of the exchange
  4. the value of an underlying asset
Show the answer to question 1

D. the value of an underlying asset

A derivative derives its value from an underlying, such as a share, an index, a commodity or a currency.

2. A participant who uses derivatives to reduce the price risk of an existing position is a

  1. arbitrageur
  2. market maker
  3. speculator
  4. hedger
Show the answer to question 2

D. hedger

Hedgers reduce risk. Speculators take risk for profit. Arbitrageurs lock in risk-free differences between markets.

3. Buying in one market and simultaneously selling in another to profit from a price difference is

  1. arbitrage
  2. speculation
  3. margin trading
  4. hedging
Show the answer to question 3

A. arbitrage

Arbitrage exploits a price difference for the same asset in two markets, without taking price risk.

Understanding index

4. A stock market index is

  1. the price of the largest share
  2. the total turnover of the exchange
  3. the average dividend of listed companies
  4. a number that represents the movement of a selected group of shares
Show the answer to question 4

D. a number that represents the movement of a selected group of shares

An index tracks the combined price movement of its constituent shares and is used as a barometer and as an underlying for derivatives.

5. In a free-float market capitalisation weighted index, the weight of a company depends on

  1. the market value of its shares available for trading
  2. its total number of employees
  3. its age
  4. its face value
Show the answer to question 5

A. the market value of its shares available for trading

Free-float methodology counts only shares readily available for trading, excluding promoter and other locked-in holdings.

Forwards and futures

6. Compared with a forward contract, a futures contract is

  1. always settled by delivery
  2. free of margin requirements
  3. standardised and traded on an exchange
  4. customised and traded privately
Show the answer to question 6

C. standardised and traded on an exchange

Futures are standardised, exchange-traded and guaranteed by the clearing corporation. Forwards are private, customised contracts with counterparty risk.

7. A trader buys one futures contract at ₹1,000. The lot size is 100. At expiry the price is ₹1,040. The profit is

  1. ₹40,000
  2. ₹40
  3. ₹4,000
  4. ₹400
Show the answer to question 7

C. ₹4,000

Profit = (1,040 − 1,000) × 100 = ₹4,000.

8. A trader sells one futures contract at ₹500 with a lot size of 200. At expiry the price is ₹520. The result is

  1. a profit of ₹20
  2. a loss of ₹4,000
  3. a profit of ₹4,000
  4. no profit or loss
Show the answer to question 8

B. a loss of ₹4,000

A seller loses when the price rises. Loss = (520 − 500) × 200 = ₹4,000.

9. Using the cost of carry model with simple interest, if the spot price is ₹1,000 and the interest rate is 12% a year, the fair price of a one month future (no dividend) is about

  1. ₹990
  2. ₹1,120
  3. ₹1,012
  4. ₹1,010
Show the answer to question 9

D. ₹1,010

F = S × (1 + r × t) = 1,000 × (1 + 0.12 × 1/12) = ₹1,010.

10. The difference between the spot price and the futures price is known as

  1. basis
  2. open interest
  3. premium
  4. margin
Show the answer to question 10

A. basis

Basis = spot price − futures price. It tends towards zero as the contract approaches expiry.

11. On the expiry day of a futures contract, the futures price and the spot price

  1. converge
  2. move apart
  3. are unrelated
  4. become zero
Show the answer to question 11

A. converge

As time to expiry falls, the cost of carry shrinks and the futures price converges to the spot price.

12. Open interest is

  1. the total number of outstanding contracts not yet closed or settled
  2. the highest price of the day
  3. the interest charged by the broker
  4. the number of contracts traded during the day
Show the answer to question 12

A. the total number of outstanding contracts not yet closed or settled

Open interest counts contracts that remain open. Volume counts contracts traded in a period.

Options

13. The buyer of a call option has

  1. the obligation to sell the underlying
  2. the right, but not the obligation, to buy the underlying at the strike price
  3. the obligation to buy the underlying
  4. the right to sell the underlying
Show the answer to question 13

B. the right, but not the obligation, to buy the underlying at the strike price

A call gives the right to buy; a put gives the right to sell. Only the seller (writer) has an obligation.

14. The price paid by the buyer of an option to the seller is the

  1. spot price
  2. premium
  3. margin
  4. strike price
Show the answer to question 14

B. premium

The premium is the price of the option. The strike price is the price at which the underlying can be bought or sold on exercise.

15. A call option has a strike price of ₹90 when the share trades at ₹100. The option is

  1. worthless
  2. at the money
  3. out of the money
  4. in the money
Show the answer to question 15

D. in the money

A call is in the money when the spot price is above the strike price.

16. A call with strike ₹90 trades at a premium of ₹14 when the spot is ₹100. Its time value is

  1. ₹0
  2. ₹10
  3. ₹4
  4. ₹14
Show the answer to question 16

C. ₹4

Intrinsic value = 100 − 90 = ₹10. Time value = premium − intrinsic value = 14 − 10 = ₹4.

17. A trader buys a call with strike ₹100 for a premium of ₹5. At expiry the share is at ₹112. Profit per share is

  1. ₹12
  2. ₹5
  3. ₹7
  4. ₹17
Show the answer to question 17

C. ₹7

Payoff = 112 − 100 = ₹12. Profit = payoff − premium = 12 − 5 = ₹7.

18. A call option has a strike price of ₹100 and was bought for a premium of ₹5. The break-even price at expiry for the buyer is

  1. ₹105
  2. ₹100
  3. ₹95
  4. ₹110
Show the answer to question 18

A. ₹105

Break-even for a long call = strike + premium = ₹105.

19. A trader buys a put with strike ₹200 for a premium of ₹8. At expiry the share is at ₹185. Profit per share is

  1. ₹23
  2. ₹7
  3. ₹15
  4. ₹8
Show the answer to question 19

B. ₹7

Payoff = 200 − 185 = ₹15. Profit = 15 − 8 = ₹7.

20. The maximum loss of the buyer of an option is

  1. unlimited
  2. the premium paid
  3. the margin deposited
  4. the strike price
Show the answer to question 20

B. the premium paid

An option buyer can lose no more than the premium. The seller of a call faces potentially unlimited loss.

21. A trader writes (sells) a call with strike ₹100 for a premium of ₹5. At expiry the share is at ₹112. The result per share is

  1. a loss of ₹12
  2. a profit of ₹7
  3. a profit of ₹5
  4. a loss of ₹7
Show the answer to question 21

D. a loss of ₹7

The writer pays out 112 − 100 = ₹12 and keeps the premium of ₹5. Net loss = ₹7.

22. An option that can be exercised only on its expiry date is

  1. a European option
  2. an exotic option
  3. an American option
  4. a Bermudan option
Show the answer to question 22

A. a European option

European options can be exercised only at expiry. American options can be exercised at any time up to expiry.

23. The Greek that measures the change in option premium for a change in the price of the underlying is

  1. delta
  2. vega
  3. rho
  4. theta
Show the answer to question 23

A. delta

Delta measures sensitivity to the underlying price. Theta is time decay, vega is sensitivity to volatility and rho to interest rates.

24. Other things equal, as an option approaches expiry its time value

  1. stays constant
  2. falls
  3. increases
  4. doubles
Show the answer to question 24

B. falls

Time value decays as expiry approaches. This decay is measured by theta and works against the buyer.

25. Other things equal, a rise in the expected volatility of the underlying will

  1. increase the premiums of both calls and puts
  2. reduce the premiums of both
  3. increase calls and reduce puts
  4. have no effect
Show the answer to question 25

A. increase the premiums of both calls and puts

Higher volatility raises the chance of large moves in either direction, making both calls and puts more valuable.

Strategies

26. An investor holds a portfolio of shares worth ₹10 lakh with a beta of 1.2. To hedge fully with index futures, the value of futures to be sold is

  1. ₹8.33 lakh
  2. ₹10 lakh
  3. ₹12 lakh
  4. ₹1.2 lakh
Show the answer to question 26

C. ₹12 lakh

Value of futures = portfolio value × beta = 10 × 1.2 = ₹12 lakh.

27. An investor owns a share and buys a put option on it. This strategy is called

  1. a covered call
  2. a straddle
  3. a protective put
  4. a bull spread
Show the answer to question 27

C. a protective put

A protective put insures a holding against a fall below the strike price, at the cost of the premium.

28. An investor owns a share and sells a call option on it. This is

  1. a covered call
  2. a naked call
  3. a protective put
  4. a long straddle
Show the answer to question 28

A. a covered call

A covered call earns premium income on a holding, in exchange for giving up gains above the strike price.

29. Buying a call and a put on the same underlying with the same strike and expiry is

  1. a covered call
  2. a long straddle
  3. a calendar spread
  4. a bull spread
Show the answer to question 29

B. a long straddle

A long straddle profits from a large move in either direction and loses if the price stays near the strike.

Trading and settlement

30. The margin collected to cover the potential loss on an open futures position for the next day is called

  1. premium
  2. brokerage
  3. exit load
  4. initial margin
Show the answer to question 30

D. initial margin

Initial margin is collected upfront. Daily gains and losses are then settled through mark-to-market.

31. The daily process of adjusting futures accounts for the day's price change is known as

  1. netting off premium
  2. delivery
  3. rollover
  4. mark-to-market settlement
Show the answer to question 31

D. mark-to-market settlement

Each day, losses are collected from and profits paid to participants based on the daily settlement price.

32. In an exchange-traded derivatives market, the settlement of trades is guaranteed by the

  1. registrar
  2. broker
  3. clearing corporation
  4. buyer
Show the answer to question 32

C. clearing corporation

The clearing corporation becomes the counterparty to both sides and guarantees settlement, removing counterparty risk.

33. The contract value of one index futures contract when the index is at 20,000 and the lot size is 50 is

  1. ₹20,000
  2. ₹4,00,000
  3. ₹1,00,000
  4. ₹10,00,000
Show the answer to question 33

D. ₹10,00,000

Contract value = index level × lot size = 20,000 × 50 = ₹10,00,000.

What next

When you can answer these without hesitation, take them in timed test mode, where the order of questions and options is shuffled and a quarter mark is deducted for a wrong answer. Then return to the workbook for every topic where you slipped. See also how to prepare and exam day.

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