LOS c: Discuss the purposes and criticisms of derivative markets.

Q1. One reason that criticism has been leveled at derivatives and derivatives markets is that:

A)   they are complex instruments and sometimes hard to understand.

B)   derivatives have too much default risk.

C)   derivatives expire.

Q2. All of the following are benefits of derivatives markets EXCEPT:

A)   transactions costs are usually smaller in derivatives markets, than for similar trades in the underlying asset.

B)   derivatives allow the shifting of risk to those who can most efficiently bear it.

C)   derivatives markets help keep interest rates down.

Q3. Which of the following is a common criticism of derivatives?

A)   Derivatives are too illiquid.

B)   Fees for derivatives transactions are relatively high.

C)   Derivatives are likened to gambling.

Q4. Which of the following statements about arbitrage is FALSE?

A)   No investment is required when engaging in arbitrage.

B)   If an arbitrage opportunity exists, making a profit without risk is possible.

C)   Arbitrage can cause markets to be less efficient.

Q5. Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT:

A)   narrow the amount of trading opportunities to a more manageable range.

B)   engage in high risk speculation.

C)   increase market efficiency through the use of arbitrage.

Q6. MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the earnings announcement the value of MBT common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than expected news. This gradual change in the value of the stock is an example of:

A)   inefficient markets.

B)   speculation.

C)   efficient markets.

LOS c: Discuss the purposes and criticisms of derivative markets. fficeffice" />

Q1. One reason that criticism has been leveled at derivatives and derivatives markets is that:

A)   they are complex instruments and sometimes hard to understand.

B)   derivatives have too much default risk.

C)   derivatives expire.

Correct answer is A)        

The fact that derivative securities are sometimes complex and often hard for non-financial commentators to understand has led to criticism of derivatives and derivative markets.

Q2. All of the following are benefits of derivatives markets EXCEPT:

A)   transactions costs are usually smaller in derivatives markets, than for similar trades in the underlying asset.

B)   derivatives allow the shifting of risk to those who can most efficiently bear it.

C)   derivatives markets help keep interest rates down.

Correct answer is C)        

The existence of derivatives markets does not affect the level of interest rates. The other statements are true.

Q3. Which of the following is a common criticism of derivatives?

A)   Derivatives are too illiquid.

B)   Fees for derivatives transactions are relatively high.

C)   Derivatives are likened to gambling.

Correct answer is C)        

Derivatives are often likened to gambling by those unfamiliar with the benefits of options markets and how derivatives are used.

Q4. Which of the following statements about arbitrage is FALSE?

A)   No investment is required when engaging in arbitrage.

B)   If an arbitrage opportunity exists, making a profit without risk is possible.

C)   Arbitrage can cause markets to be less efficient.

Correct answer is C)        

Arbitrage is defined as the existence of riskless profit without investment and involves selling an asset and simultaneously buying the same asset for a lower price. Since the trades cancel each other, no investment is required. Because it is done simultaneously, a profit is guaranteed, making the transaction risk free. Arbitrage actually helps make markets more efficient because price discrepancies are immediately eradicated by the actions of arbitrageurs.

Q5. Financial derivatives contribute to market completeness by allowing traders to do all of the following EXCEPT:

A)   narrow the amount of trading opportunities to a more manageable range.

B)   engage in high risk speculation.

C)   increase market efficiency through the use of arbitrage.

Correct answer is A)        

Financial derivatives increase the opportunities to either speculate or hedge on the value of underlying assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders.

Q6. MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the earnings announcement the value of MBT common stock increased each day for the next five trading days, as analysts and investors gradually reacted to the better than expected news. This gradual change in the value of the stock is an example of:

A)   inefficient markets.

B)   speculation.

C)   efficient markets.

Correct answer is A)        

A critical element of efficient markets is that asset prices respond immediately to any new information that will affect their value. Large numbers of traders responding in similar fashion to the new information will create a temporary imbalance in supply and demand, and this will adjust asset market values.

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