R02 Derivatives: free practice questions

1. Question 1 of 5

   What is a derivative?

   Option A: A contract whose value comes from an underlying assetOption B: A share in a company that trades in commoditiesOption C: A fund that tracks an indexOption D: A bond issued by a central bank

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   The answer is A: A contract whose value comes from an underlying asset

   A derivative derives its value from an underlying investment, such as commodities, bonds, currencies, interest rates, shares or indices. Derivatives can reduce risk by hedging or increase it through speculation.

   Why the other options are wrong

   B

   That's an equity, not a derivative.

   C

   That's a tracker or ETF.

   D

   That's a government security.

2. Question 2 of 5

   An investor buys futures contracts. What position does she hold, and what does she hope will happen?

   Option A: A long position; she hopes prices will fallOption B: A long position; she hopes prices will riseOption C: A neutral position; she's indifferentOption D: A short position; she hopes prices will fall

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   The answer is B: A long position; she hopes prices will rise

   Buyers of futures are long: they must buy at the agreed price and gain if prices rise. Sellers are short: they must deliver and gain if prices fall.

   Why the other options are wrong

   A

   A buyer profits if prices rise.

   C

   Buying futures gives market exposure.

   D

   That's the seller's position.

3. Question 3 of 5

   Who has to pay margin on an exchange-traded option?

   Option A: Neither partyOption B: The writer, but not the buyerOption C: The buyer, but not the writerOption D: Both the buyer and the writer

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   The answer is B: The writer, but not the buyer

   The holder pays the premium plus commission but no margin. The writer receives the premium but must deposit initial margin and meet daily variation margin calls.

   Why the other options are wrong

   A

   The writer must deposit margin.

   C

   The buyer pays the premium, not margin.

   D

   Only the writer pays margin.

4. Question 4 of 5

   A share is trading at 640p. How would you describe a put option on it with a strike price of 600p?

   Option A: In-the-moneyOption B: Out-of-the-moneyOption C: Worthless, as it can't be tradedOption D: At-the-money

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   The answer is B: Out-of-the-money

   A put has intrinsic value only when the share price is below the strike price. At 640p against a 600p strike, it's out-of-the-money; any value it has is time value.

   Why the other options are wrong

   A

   A put is in-the-money only if the share is below the strike.

   C

   It may still have time value before expiry.

   D

   That would need the share price to equal the strike.

5. Question 5 of 5

   A fund writes call options over shares it already owns. What is the main trade-off?

   Option A: It must buy more shares if the price fallsOption B: It earns premium income but gives up gains above the strikeOption C: It faces unlimited losses if the share price rises sharplyOption D: It pays a premium and gets the right to sell

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   The answer is B: It earns premium income but gives up gains above the strike

   Covered call writing earns premium income. If the share rises above the strike, the shares are handed over at that price, forgoing further profits. The biggest risks come from writing uncovered calls.

   Why the other options are wrong

   A

   That's the obligation of a put writer.

   C

   That applies to uncovered calls.

   D

   That describes buying a put.

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