# Multiple choice questions on derivatives, investments

MULTIPLE CHOICE QUESTIONS

1. In a forward contract the party who commits to sell an asset at a specified date in the future takes a(n) position, and the party who commits to buy an asset at a specified date in the future takes a(n) position.

(a) risk seeking; risk averse

(b) open; closed

(c) closed; open

(d) short; long

(e) long; short

2. Assume the one year forward rate for a share of stock is $45, the spot price is $41 and the risk free rate is 5% pa. The observed forward price is and the implied forward price is :

(a) $45; $41

(b) $45; $43.05

(c) $41; $45

(d) $41; $43.05

(e) $45; $38.95

3. An investment strategy that requires no outlay of an investor's own money to generate positive riskless profits is:

(a) arbitrage

(b) risk seeking

(c) portfolio replicating

(d) beta adjusting

(e) minimum variance

4. An OTC forward contract is:

(a) an option to call

(b) a forward contract for which the payback is outside the contract period

(c) a customised agreement that is not traded on an exchange

(d) a standardised agreement that is traded on an exchange

(e) a forward contract in which the spot price of the asset at maturity is over the contract forward price

5. The NZ dollar risk free rate is r$ = 3.0% pa, the euro risk free rate is r? = 7.0% pa, the euro is currently trading at NZ$2.04 per ?. The implied forward NZ dollar against euro exchange rates at 3 months and at one year are:

(a) NZ$2.06 per ?; NZ$2.12 per ?

(b) NZ$2.12 per ?; NZ$2.06 per ?

(c) NZ$2.02 per ?; NZ$1.96 per ?

(d) NZ$2.00 per ?; NZ$1.96 per ?

(e) NZ$1.96 per ?; NZ$2.00 per ?

6. A dealer in a commodity is considering a trade in a forward contract. The current spot price of the commodity is $500 per unit, the forward price for delivery in 1 year is $540 per unit and the annual inventory costs are 2% of the current spot price. The implied risk free rate is , and the arbitrage profit that could be earned per unit of the commodity in period 1 if the risk-free rate of return is 5% pa in period 0 is .

(a) 4.0%; $4.20

(b) 5.5%: $5.09

(c) 5.5%; $2.70

(d) 6.0%; $5.00

(e) 6.0%; $5.40

Questions 7-12 refer to the following information.

Consider a market consisting of only two assets, A and B. There are 100 shares of asset A in the market and the price per share is $1.00. There are 100 shares of asset B in the market and the price per share is $2.00.

Asset A has an average rate of return, A = 10%.

Asset B has an average rate of return, B = 6%.

The risk free interest rate is 5%.

The standard deviation of the market return is 20%.

Assume the market satisfies the CAPM.

7. The asset allocation in the market portfolio is:

(a) A = 1/2 ; B = 1/2

(b) A = 1/4 ; B = 3/4

(c) A = 3/4 ; B = 1/4

(d) A = 2/3 ; B = 1/3

(e) A = 1/3 ; B = 2/3

8. The expected return from the market portfolio is:

(a) 7.00%

(b) 7.33%

(c) 8.00%

(d) 8.67%

(e) 9.00%

9. The betas of assets A and B are:

(a) A = 1.36 ; B = 0.82

(b) A = 1.36 ; B = 0.27

(c) A = 1.15 ; B = 0.69

(d) A = 1.67 ; B = 0.33

(e) A = 2.14 ; B = 0.43

10. The covariance of the market with asset A is:

(a) 0.0857

(b) 0.0784

(c) 0.0667

(d) 0.0545

(e) 0.0500

11. The equation of the CML is:

(a)

(b)

(c)

(d)

(e)

12. An investment opportunity in the market offers an expected return of 6% with a standard deviation of 19%. If you invested all your money in this opportunity where would your portfolio lie in relation to the CML?

(a) at the point of intersection of the CML and the vertical axis

(b) at the point of intersection of the CML and the horizontal axis

(c) above the CML

(d) below the CML

(e) cannot be determined from the information given

Questions 13-14 refer to the following information.

Consider an economy in which the risk free interest rate is 5%, the return to the market portfolio is 15% and the standard deviation of the return to the market portfolio is 20%.

A firm's shares are currently trading at $20 per share.

A market analyst reports that the firm's expected dividend is $2 and it is expected that the share price will remain constant.

Assume the firm's beta is 0.1.

13. What is the expected return from the stock and the stock's risk premium?

(a) 17%; 12%

(b) 25%; 5%

(c) 25%; 20%

(d) 10%; 15%

(e) 10%; 5%

14. What is the risk premium suggested by CAPM? According to CAPM are the firm's shares over-priced or under-priced?

(a) 10%; over-priced

(b) 10%; over-priced

(c) 1%; under-priced

(d) 1%; over-priced

(e) 5%; correctly priced

15. Assume the standard deviation of the market return is 0.2, the standard deviation of asset k is 0.45 and the beta of asset k is 0.675. The correlation coefficient between the return from asset k and the return from the market is:

(a) 0.900

(b) 0.658

(c) 0.444

(d) 0.300

(e) 0.133

16. A portfolio comprises two risky assets. As the correlation between the two assets decreases the standard deviation of the minimum variance portfolio and the standard deviation of the tangency portfolio :

(a) increases; decreases

(b) increases; increases

(c) remains unchanged; decreases

(d) decreases; increases

(e) decreases; decreases

17. A call option is in-the-money if the:

(a) strike price of the option is less than the current price of the underlying asset

(b) strike price of the option is greater than the current price of the underlying asset

(c) strike price of the option is equal to the price of the underlying asset

(d) intrinsic value of the option is zero

(e) settlement date is less than one month from the current date

18. The forward short position with a forward price of E has the same gross return as the combination of which two option positions, each with strike price E?

(a) long call and short put

(b) long put and short call

(c) long call and long put

(d) short put and short call

(e) none of the above

19. The price of a put option as the volatility of the returns of the underlying asset increases, and the price of a put option as the time to expiration decreases.

(a) decreases; remains unchanged

(b) decreases; decreases

(c) increases; increases

(d) increases; remains unchanged

(e) increases; decreases

20. Which of the following statements is NOT true of the Black-Scholes model?

(a) vega is always positive

(b) N(d1) is the  of the call option

(c) N(d2) is the  of the put option

(d) the volatility of the underlying asset is the annualised standard deviation of its returns

(e) the volatility of the underlying asset is assumed to be constant

Questions 21-25 refer to the following information.

Assume the current price of a stock is $43 and the volatility is 0.2. Assume the stock is not expected to pay dividends during the next 6 months. Assume the risk-free interest rate is 10% pa.

21. The Black-Scholes model suggests that the price of a 6 month European call option on the stock where the exercise price of the option is $40 is:

(a) $6.29

(b) $5.56

(c) $4.83

(d) $3.72

(e) $1.86

22. What is the intrinsic value of the call option? What is its the time value?

(a) $4.00; $0.35

(b) $2.72; $1.00

(c) $3.00; $2.56

(d) $3.00; $3.29

(e) $0; $4.83

23. The probability that the call option expires in-the-money is approximately:

(a) 0.94

(b) 0.83

(c) 0.79

(d) 0.17

(e) 0.06

24. The Black-Scholes model suggests that the price of a 6 month European put option on the stock where the exercise price of the option is $40 is:

(a) $0.61

(b) $0.78

(c) $0.84

(d) $1.34

(e) $2.63

25. The call option is , and the put option is :

(a) in-the-money; at-the-money

(b) out-of-the-money; in-the-money

(c) at-the-money; at-the-money

(d) in-the-money; out-of-the-money

(e) out-of-the-money; at-the-money

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MULTIPLE CHOICE QUESTIONS

1. In a forward contract the party who commits to sell an asset at a specified date in the future takes a(n) position, and the party who commits to buy an asset at a specified date in the future takes a(n) position.

(a) risk seeking; risk averse

(b) open; closed

(c) closed; open

(d) short; long

(e) long; short

Answer: (d) short; long

2. Assume the one year forward rate for a share of stock is $45, the spot price is $41 and the risk free rate is 5% pa. The observed forward price is and the implied forward price is :

(a) $45; $41

(b) $45; $43.05

(c) $41; $45

(d) $41; $43.05

(e) $45; $38.95

Answer: (b) $45; $43.05

Observed forward price = Quoted Forward price= $ 45

Implied Forward price = Spot price x (1+ risk free rate) = $41 x (1+0.05) = $ 43.05

3. An investment strategy that requires no outlay of an investor's own money to generate positive riskless profits is:

(a) arbitrage

(b) risk seeking

(c) portfolio replicating

(d) beta adjusting

(e) minimum variance

Answer: (a) arbitrage

4. An OTC forward contract is:

(a) an option to call

(b) a forward contract for which the payback is outside the contract period

(c) a customised agreement that is not traded on an exchange

(d) a standardised agreement that is traded on an exchange

(e) a forward contract in which the spot price of the asset at maturity is over the contract forward price

Answer: (c ) a customised agreement that is not traded on an exchange

An OTC (Over the counter) contract is a customized contract and not a standardized contract. Forward contracts are not traded over an exchange. (Futures contracts are standardized contracts that are traded over an exchange.)

5. The NZ dollar risk free rate is r$ = 3.0% pa, the euro risk free rate is r? = 7.0% pa, the euro is currently trading at NZ$2.04 per ?. The implied forward NZ dollar against euro exchange rates at 3 months and at one year are:

(a) NZ$2.06 per ?; NZ$2.12 per ?

(b) NZ$2.12 per ?; NZ$2.06 per ?

(c) NZ$2.02 per ?; NZ$1.96 per ?

(d) NZ$2.00 per ?; NZ$1.96 per ?

(e) NZ$1.96 per ?; NZ$2.00 per ?

Answer: (c) NZ$2.02 per ?; NZ$1.96 per ?

Forward rate = Spot rate x (1 + NZ dollar risk free rate x n/12) / (1 + Euro risk free rate x n/12)

Where n = number of months

When n= 3

Forward rate = NZ$2.04 per ?. x (1 + 3% x 3/12) / (1 + 7% x 3/12) = NZ$2.02 per ?

When n= 12

Forward rate = NZ$2.04 per ?. x (1 + 3% x 12/12) / (1 + 7% x 12/12) = NZ$1.96 per ?

6. A dealer in a commodity is considering a trade in a forward contract. The current spot price of the commodity is $500 per unit, the forward price for delivery in 1 year is $540 per unit and the annual inventory costs are 2% of the current spot price. The implied risk free rate is , and the arbitrage profit that could be earned per unit of the commodity in period 1 if the risk-free rate of return is 5% pa in period 0 is .

(a) 4.0%; $4.20

(b) 5.5%: $5.09

(c) 5.5%; $2.70

(d) 6.0%; $5.00

(e) 6.0%; $5.40

Answer: 6.0%; $5.00

Forward rate = Spot rate x (1+ risk free rate + inventory cost)

$ 540 = $ 500 x (1+ risk free rate + 2%)

Or (1+ risk free rate + 2%) = $ 540 / $ 500 = 1.08

Or risk free rate = 1.08 -1-0.02 = 0.06 or 6%

If risk free rate =5%

Forward rate = $ 500 x (1+ 5% + 2%) = $ 535

Arbitrage profit = $ 540 - $535= $5

Questions 7-12 refer to the following information.

Consider a market consisting of only two assets, A and B. There are 100 shares of asset A in the market and the price per share is $1.00. There are 100 shares of asset B in the market and the price per share is $2.00.

Asset A has an average rate of return, A = 10%.

Asset B has an average rate of return, B = 6%.

The risk free interest rate is 5%.

The standard deviation of the market return is 20%. ...

#### Solution Summary

Answers 25 multiple choice questions on derivatives, international finance, investments

30 Finance multiple choice questions

1. The goal of the firm should be

a. maximization of profits

b. maximization of shareholder wealth

c. maximization of consumer satisfaction

d. maximization of sales

2. An example of a primary market transaction is

a. a new issue of common stock by AT&T

b. a sale of some outstanding common stock of AT&T

c. AT&T repurchasing its own stock from a stockholder

d. one stockholder selling shares of common stock to another individual

3. According to the agency problem, _________ represent the principals of a corporation.

a. Shareholders

b. Managers

c. Managers

d. Suppliers

4. Which of the following is a principle of basic financial management?

a. Risk/return tradeoff

b. Derivatives

c. Stock warrants

d. Profit is king

5. Another name for the acid test ratio is the

a. current ratio

b. quick ratio

c. inventory turnover ratio

d. inventory turnover ratio

6. The accounting rate of return on stockholders' investments is measured by

a. return on assets

b. return on equity

c. operating income return on investment

d. realized rate of inflation

7. If you are an investor, which of the following would you prefer?

a. Earnings on funds invested compound annually

b. Earnings on funds invested compound daily

c. Earnings on funds invested would compound monthly

d. Earnings on funds invested would compound quarterly

8. The primary purpose of a cash budget is to

a. determine the level of investment in current and fixed assets

b. determine accounts payable

c. provide a detailed plan of future cash flows

d. determine the estimated income tax for the year

9. Which of the following is a non-cash expense?

a. Depreciation expenses

b. Interest expense

c. Packaging costs

d. Administrative salaries

10. The break-even model enables the manager of a firm to

a. calculate the minimum price of common stock for certain situations

b. set appropriate equilibrium thresholds

c. determine the quantity of output that must be sold to cover all operating costs

d. determine the optimal amount of debt financing to use

11. A zero-coupon bond

a. pays no interest

b. pays interest at a rate less than the market rate

c. is a junk bond

d. is sold at a deep discount at less than the par value

12. If you have $20,000 in an account earning 8% annually, what constant amount could you withdraw each year and have nothing remaining at the end of 5 years?

a. $3,525.62

b. $5,008.76

c. $3,408.88

d. $2,465.78

13. At what rate must $400 be compounded annually for it to grow to $716.40 in 10 years?

a. 6%

b. 5%

c. 7%

d. 8%

14. The present value of a single future sum

a. increases as the number of discount periods increase

b. is generally larger than the future sum

c. depends upon the number of discount periods

d. increases as the discount rate increases

15. Which of the following is considered to be a spontaneous source of financing?

a. Operating leases

b. Accounts receivable

c. Inventory

d. Accounts payable

16. Compute the payback period for a project with the following cash flows, if the company's discount rate is 12%.

Initial outlay = $450

Cash flows:

Year 1 = $325

Year 2 = $65

Year 3 = $100

a. 3.43 years

b. 3.17 years

c. 2.88 years

d. 2.6 years

17. For the NPV criteria, a project is acceptable if the NPV is __________, while for the profitability index, a project is acceptable if the profitability index is __________.

a. less than zero, greater than the required return

b. greater than zero, greater than one

c. greater than one, greater than zero

d. greater than zero, less than one

18. Which of the following is considered to be a deficiency of the IRR?

a. It fails to properly rank capital projects.

b. It could produce more than one rate of return.

c. It fails to utilize the time value of money.

d. It is not useful in accounting for risk in capital budgeting.

19. The firm should accept independent projects if

a. the payback is less than the IRR

b. the profitability index is greater than 1.0

c. the IRR is positive

d. the NPV is greater than the discounted payback

20. The most expensive source of capital is

a. preferred stock

b. new common stock

c. debt

d. retained earnings

21. The cost associated with each additional dollar of financing for investment projects is

a. the incremental return

b. the marginal cost of capital

c. risk-free rate

d. beta

22. The XYZ Company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required rate of return on debt is 9%, and the required rate of return on equity is 14%. If the company is in the 40% tax bracket, what is the marginal cost of capital?

a. 14.0%

b. 14.0%

c. 10.6%

d. 11.5%

23. Shawhan Supply plans to maintain its optimal capital structure of 30% debt, 20% preferred stock, and 50% common stock far into the future. The required return on each component is: debt-10%; preferred stock-11%; and common stock-18%. Assuming a 40% marginal tax rate, what after-tax rate of return must Shawhan Supply earn on its investments if the value of the firm is to remain unchanged?

a. 18.0%

b. 13.0%

c. 10.0%

d. 14.2%

24. Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers' present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $1,440,000, but only 228,571 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%?

a. $1.75

b. $2.00

c. $3.25

d. $4.50

25. Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock. If Zybeck issues common stock this year, what will be the projected EPS next year?

a. $4.94

b. $2.96

c. $5.33

d. $3.20

26. _________ risk is generally considered only a paper gain or loss.

a. Transaction

b. Translation

c. Economic

d. Financial

27. Capital markets in foreign countries

a. offer lower returns than those obtainable in the domestic capital markets

b. provide international diversification

c. in general are becoming less integrated due to the widespread availability of interest rate and currency swaps

d. in general are becoming less integrated due to the widespread availability of interest rate and currency swaps

28. Buying and selling in more than one market to make a riskless profit is called

a. profit maximization

b. arbitrage

c. international trading

d. an efficient market

29. What keeps foreign exchange quotes in two different countries in line with each other?

a. Cross rates

b. Forward rates

c. Arbitrage

d. Spot rates

30. One reason for international investment is to reduce

a. portfolio risk

b. price-earnings (P/E) ratios

c. advantages in a foreign country

d. exchange rate risk