Introduction
Derivatives like options, futures, and swaps are financial instruments derived from underlying assets. This guide explores their mechanics through multiple-choice questions (MCQs) and detailed explanations, ideal for students and professionals preparing for finance exams or practical trading.
Core MCQ Questions & Explanations
1. Bull Spread Strategy Using Call Options
Question:
In a bull spread strategy using call options:
- A) Both options have the same strike price
- B) The option sold has a higher strike price than the option bought
- C) The option sold has a lower strike price than the option bought
- D) Both options have different expiration dates
Answer: B
Explanation:
A bull spread involves buying a call option at a lower strike price and selling another at a higher strike price. This limits both profit and loss while capitalizing on moderate price rises.
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2. Leverage in Derivatives
Question:
Which derivative provides leverage?
- A) Futures contracts
- B) CDOs
- C) Treasury bills
- D) Corporate bonds
Answer: A
Explanation:
Futures allow traders to control large positions with minimal margin, amplifying gains (or losses).
3. Role of Swap Dealers
Question:
What best describes a swap dealer?
- A) Individual trading swaps on exchanges
- B) Financial institution facilitating swaps
- C) Government regulator
- D) Corporate issuer
Answer: B
Explanation:
Swap dealers act as intermediaries, ensuring liquidity and customization in OTC markets.
Key Derivatives Concepts
Types of Derivatives
| Instrument | Purpose | Example |
|-------------|----------------------------------|--------------------------|
| Options | Right (not obligation) to buy/sell | Call/Put on stocks |
| Futures | Obligation to buy/sell at future date | Oil futures |
| Swaps | Exchange cash flows (e.g., interest rates) | Interest rate swaps |
FAQs
Q1: What’s the difference between futures and forwards?
A: Futures are standardized and exchange-traded; forwards are customized OTC contracts.
Q2: How does delta hedging work?
A: It offsets price movements in the underlying asset by adjusting the option’s delta (e.g., buying/selling shares).
Q3: Why use Monte Carlo simulation?
A: To price complex derivatives (e.g., path-dependent options) by modeling random price paths.
Conclusion
Understanding derivatives is crucial for risk management and speculative strategies. This MCQ guide clarifies core concepts, from option strategies to swap mechanics, ensuring a solid foundation for further study.