Practice Questions with Answers: Basics of Derivative Pricing and Valuation

1. Which of the following is most accurate about a replication strategy?

A. Long Asset = Long Risk- Free Bond + Long Forward

B. Long Forward = Long Asset + Short Forward
C. Short Risk-free bond + Long Asset = Short Forward
D. Short Forward = Long Asset + Long Risk-Free Bond

Answer: A
Going long on an asset gives the same return as lending funds on the risk-free rate and going long in a
forward. In this way, you can replicate the payoffs on an underlying asset with a position in the risk-free
asset and a derivative contract.

2. Which of the following is not a factor in determining a derivative’s price?

A. Market price of the underlying

B. Riskiness of the underlying
C. Risk-free interest rate
D. Time value of money

Answer: B
Derivatives are priced under the principle of Neutrality.
We know that most investors are risk-averse. Unlike other assets though, risk aversion does not have an
impact on derivative pricing. Therefore, we say that those investing in a derivative are risk-neutral; they
are indifferent as to the level of risk they’ll expose themselves to. Instead, the price of a derivative is
based on a risk-free rate, just like a government bond. That is because the no-arbitrage principle
presupposes a risk-free return. So, when we price a derivative, we assume that there is no risk premium
involved. Please note that there is only one price that can achieve risk neutrality.
3. Today, an asset is trading at $50 and the risk-free interest rate is 7%. Ben enters in a forward
contract to buy this asset after 6 months. What is the price of this forward?

A. $53.5
B. $55.3
C. $51.7
D. $54.0

Answer: C
F0(T) = S0 (1+r)T = 50(1.07)6/12 = $51.7

4. What is the value of the forward contract at expiration from Ben’s perspective (use the
information given in Q3) provided the asset’s spot price is $55?

A. $3.3
B. $2.5
C. $2.0
D. $0

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Answer: A
VT = ST – F0(T) = 55 – 51.7 = $3.3

5. An asset’s market price today is $500. If there is a futures contract agreed on it today, what
would be the present value of the futures price at contract initiation? The interest rate is 10%.

A. $0
B. $550
C. $500
D. $600

Answer: C
At no-arbitrage, the present value of the futures price is equal to the current spot price of the
underlying.

6. A futures price will go up when the Net cost of carry is:

A. ϒ – θ is positive
B. ϒ – θ is negative
C. ϒ – θ is 0
D. θ – ϒ is negative

Answer: B
A futures price increases with an increase in associated costs, as the long party is willing to compensate
for their expenses by selling the asset at a higher price.

7. What will be the Forward Price when ― the underlying’s market price at contract initiation is
$40, benefits are $20, costs are $18, the risk-free interest rate is 5%, and the contract’s term is 3
months?

A. $38.00
B. $38.47
C. $43.99
D. $40.49

Answer: B
F0(T) = (S0 - ϒ + θ) (1+r)T = (40-20+18)(1+5%)3/12

F0(T) = $38.47

Anna entered a forward agreement to buy 100 shares of company X. The duration of the contract is 1
year, and the exercise price is $150. The risk-free interest rate is 10%
8. What is the present value of the forward price after 6 months have passed?
A. $165
B. $145
C. $157
D. $150
Answer: C
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 F0(T) = S0 x (1+r)t = 150 x (1.1)0.5
F0(T) = $157

9. What would be the forward’s value for Anna after 6 months have passed? The Market price of
100 shares totals $145.

A. $0
B. -$12
C. -$13
D. $12

Answer: B
Vt(T) = St – F0(T)(1+r)-(T-t)
Vt(T) = 145 – 157
Vt(T) = -$12

10. Anthony fixed a 10% interest rate for a forward that he agrees to buy after 10 days and to settle
after 40 days. What type of forward contract is this?

A. Vanilla Forward
B. Simple Forward
C. Forward Rate Agreement
D. Interest rate Agreement

Answer: C
When the underlying in a forward contract is an interest rate, it is known as a Forward Rate Agreement
(FRA). FRAs can be used by both debtors and creditors to hedge against their respective positions and
expected losses. At the end of the day, the party that “guessed” the direction of the change generates a
profit, while the other one incurs a loss. It is a zero-sum game.

11. In a FRA, the agreed rate between both parties is 10% whereas the market rate at the lending
date is $11.5%. Which party benefits in this transaction?

A. Long party
B. Short party
C. Both parties
D. Neither party

Answer: A
As the market price/rate increases, the long party benefits from the low forward rate, as now they will
be borrowing at lower interest charges.

12. A single period swap resembles:

A. Single Futures Contract

B. Single Forward Contract
C. Series of Forward Contracts
D. None of the above
Answer: B
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Because swaps comprise cash flow exchange at definite intervals, we can say that each interval
resembles a single forward contract. The value of implied forwards at the contract’s initiation is not
going to be 0 due to off-market forward rates. The price for each forward is either more or less than
what should have been at no-arbitrage, meaning that the value at initiation is either positive or
negative. However, when we add the values of all the periods together, they will ultimately sum up to
zero. Hence, a single period swap (with only one transaction interval) is equal to a single forward
contract. In turn, swaps with multiple payment intervals exhibit implied forwards which differ from each
other.

13. A swap has 3 payment points. Roy makes a fixed payment of 10% throughout the contract, while
Lacie follows a floating rate: 9%, 10%, and 11% at each point respectively.
How much did Roy pay in each of the three terms (expressed as a % difference)?
A. 1%,0,0
B. 1%,0,1%
C. 10%,10%,10%
D. 0,0,1%

Answer: A
At the first payment interval, Roy owes 10% and receives 9%, so he makes a net payment of 1% to Lacie.
At the second interval, payment and receipt net off against each other, as both parties owe 10%, so 0.
At the third interval, Roy owes 10% and receives 11%, so he makes no payments. Instead, he receives
1% from Lacie.

14. Which of the following is not likely to be true about swap contracts?

A. F1(T) equals F2(T)

B. F1(T) does not equal F2(T)
C. The sum of all payments’ present value is 0 at contract initiation
D. The losing party only settles the difference between the two amounts

Answer: A
F(T) is the price at each interval, and payments at each interval are not identical (due to the time
difference of each implied forward contract).

15. What is the fixed-rate payment of a 90-day swap, where the notional principal is $10,000, LIBOR
is 8%, and the fixed interest rate is 10%?

A. $40
B. $50
C. $250
D. $1,000

Answer: B
Fixed-rate payment (t) = (Swap FR – LIBOR) x T/360 x NP Plain Vanilla Interest Rate Swap
Fixed-rate payment (t) = (0.10-0.08) x 90/360 x 10,000
Fixed-rate payment (t) = $50
16. A protective put is derived by:
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 A. S0 + p0
B. S0 + c0
C. P0 + c0
D. ST + p0

Answer: A
The Put-Call Parity is a principle that characterizes the relationship between European put options and
European call options of the same “rank”. In the formula below, the right-hand side of the expression
represents the Protective Put:

When a long position on an asset is combined with a short position on an option, it is called a protective
put. In other words, it is a long-put option joined with the underlying asset. Its name stems from the fact
that we protect our position by using a long put. Provided that both portfolios derive their values from
the very same underlying asset, their exercise prices will end up being identical.

17. The value of the protective put is equal to:

A. c0 + X/(1+r)T
B. Fiduciary Call
C. Both of the above
D. None of the above

Answer: C
According to the Put-Call Parity principle, the Fiduciary Call should equal the Protective Put.
Fiduciary Call = c0 + X/(1+r)T
Protective Put = S0 + p0

18. Assume that an asset’s price at initiation is $100. The exercise price of each option is $110, the
call value is $0, and the risk-free rate is 5%. At what value of the put option, would the put-call
parity hold true (for one-year options)?

A. $5
B. $6
C. $7
D. $8

Answer: A
S0 + p0 = c0 + X/(1+r)T
100+p0 = 0 + 110/(1+0.05)1
P0 = $5

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 19. You are given the following information: F0(T) = $80, r = 4%, T = 0.5 (6 months), p0=$0, c0=$15.
Using the formula for Put-Call Forward parity, what would be the exercise price in each option?

A. $74
B. $64
C. $54
D. $60

Answer: B
F0(T)/(1+r)T + p0 = c0 + X/(1+r)T
80/ (1.04)0.5 + 0 = 15 + X/ (1.04)0.5
X = (78.4 – 15) x 1.02
X = $64

20. The underlying asset is trading at $20 at contract initiation. The expected value of the underlying
asset after T=1 is $30. What is its up factor (u)?
A. 1.5
B. 0.5
C. 1
D. 2

Answer: A
S1+ = S0 x u
30 = 20 x u
u = 30/20 = 1.5

21. You are given the following information: S0 = $10, d (down factor) = 0.3. Please select the S1-
value of the asset.
A. $3
B. $6
C. $33
D. $10

Answer: A
S1- = S0 x d = 10 x 0.3 = $3

22. Based on the risk-neutral probability formula, find the risk-neutral probability an option when
the up factor is 1.1, the down factor is 0.7, and the interest rate is 3%.
A. 0.6
B. 0.7
C. 0.8
D. 1.0

Answer: C
π = (1+r-d) / (u-d)
= (1+0.03 – 0.7)/ (1.1-0.7) = 0.8

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 23. You are given the following information: Pie = 11, c1 plus = $10, c1 minus = $4, r = 6%. Calculate
the value of a call option using the binomial formula.
A. $67
B. $66
C. $65
D. $63

Answer: B
c0 = (pie xc1+ + c1- x (1 – pie))/(1+r)
= (11 x 10 + 4 x (1-11))/1.06
= $66

24. Which of the statements is true about American call options?

A. C0 is always greater than c0.
B. C0 is always lesser than c0.
C. C0 is always greater than or equal to c0.
D. C0 is always equal to c0.

Answer: C
The value of American call options is always equal to or higher than the value of similar European call
options.
In terms of call options, both European and American types have the same value, only if there are no
cash flows involved. Since the holder has no incentive to exercise their right to buy early, the values
remain identical.

But what happens if there are any dividend or interest payments due during the life of an option?

In this situation, the American holder may exercise their right to buy early and become entitled to the
cash flows as well. That is why an American option is perceived to be more valuable in this scenario