CAIIB BFM Module C Unit 24 MCQ: Derivative Products

CAIIB BFM Module C Unit 24 MCQ: Derivative Products. 94 MCQs explaining OTC, exchange-traded products, hedging, and speculation.

CAIIB BFM Module C Unit 24 MCQ: Derivative Products – Attempt Now!

Question 1: What is the main idea of a derivative in finance?

A. It is the original asset itself, like a bond or stock.
B. Its value comes from another asset, index, or event.
C. It is a type of currency used for international trade.
D. It is a government rule about financial markets.

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Correct Answer: B. Its value comes from another asset, index, or event. A derivative’s worth is linked to the performance of an underlying asset, index, or event.

Question 2: Which of the following is a way that a treasury might use derivatives?

A. To store physical gold reserves.
B. To manage financial risks like changes in interest rates.
C. To print more money for the country.
D. To provide loans directly to citizens.

Show Explanation

Correct Answer: B. To manage financial risks like changes in interest rates. Treasury departments use derivatives for risk management, such as Asset Liability Management (ALM).

Question 3: What mainly decides the value of a derivative?

A. The historical cost of setting up the contract.
B. The expected prices of the related asset in the future.
C. The current profit of the company selling the derivative.
D. The total number of derivatives available in the market.

Show Explanation

Correct Answer: B. The expected prices of the related asset in the future. The value of a derivative is closely tied to the anticipated future price movements of its underlying asset.

Question 4: What are two important basic features of a derivative contract?

A. The physical size of the asset and its storage location.
B. The notional amount and the agreed terms for settlement.
C. The names of the lawyers who drafted the contract and their fees.
D. The number of pages in the contract and the color of the paper used.

Show Explanation

Correct Answer: B. The notional amount and the agreed terms for settlement. A derivative contract specifies a notional amount and the conditions under which it will be settled.

Question 5: What are Over-the-Counter (OTC) derivatives?

A. Derivatives that can only be bought by government agencies.
B. Derivatives that are negotiated privately between two parties.
C. Derivatives that are traded on public stock exchanges.
D. Derivatives that are free of any cost or fees.

Show Explanation

Correct Answer: B. Derivatives that are negotiated privately between two parties. OTC derivatives are customized contracts agreed upon directly between two parties, often a bank and a client.

Question 6: How are the terms of an OTC derivative usually decided?

A. They are set by a central government authority.
B. They are standardized by a stock exchange.
C. They are negotiated and agreed upon by the two parties involveD.
D. They are automatically generated by a computer program.

Show Explanation

Correct Answer: C. They are negotiated and agreed upon by the two parties involved. The amount, date, and specific details of an OTC derivative contract can be customized through negotiation.

Question 7: Who usually provides the price for an OTC derivative?

A. A neutral third-party organization.
B. The buyer of the derivative.
C. The seller of the derivative, which is often a bank or financial institution.
D. The government’s financial regulatory body.

Show Explanation

Correct Answer: C. The seller of the derivative, which is often a bank or financial institution. Dealers, such as banks, quote the price for OTC derivatives, which includes their profit margin.

Question 8: What is a key risk associated with OTC derivatives?

A. The risk that the price of the underlying asset will not change.
B. The risk that the other party in the contract might fail to meet their obligations.
C. The risk that the contract will last for too long.
D. The risk that too many people will want to trade the derivative.

Show Explanation

Correct Answer: B. The risk that the other party in the contract might fail to meet their obligations. Counterparty risk is a significant concern in OTC derivatives, as it involves the possibility of default by the other party.

Question 9: How are margin or collateral requirements typically determined for OTC derivatives?

A. They are fixed by international law.
B. They are decided by the buyer of the derivative.
C. They are set by the dealer (bank or financial institution).
D. They are not required for OTC derivatives.

Show Explanation

Correct Answer: C. They are set by the dealer (bank or financial institution). The dealer in an OTC derivative transaction usually determines the margin or collateral needed.

Question 10: What is the main purpose for which OTC derivatives are used?

A. To make quick profits through speculation.
B. To reduce or eliminate specific existing risks.
C. To increase the overall amount of money in the economy.
D. To provide a platform for small investors to trade.

Show Explanation

Correct Answer: B. To reduce or eliminate specific existing risks. OTC derivatives are primarily used for hedging, which involves protecting against potential losses.

Question 11: How is the settlement of an OTC derivative often done?

A. Usually through a public auction of the underlying asset.
B. Often by the actual transfer of the underlying asset.
C. Always by exchanging a fixed amount of golD.
D. By donating the profits to a charity.

Show Explanation

Correct Answer: B. Often by the actual transfer of the underlying asset. Settlement of OTC derivatives can involve the physical delivery of the underlying asset.

Question 12: What are Exchange-Traded Derivatives (ETDs)?

A. Derivatives that are traded secretly between very few people.
B. Derivatives that are bought and sold on organized exchanges.
C. Derivatives that are only available to expert traders.
D. Derivatives that are not regulated by any financial authority.

Show Explanation

Correct Answer: B. Derivatives that are bought and sold on organized exchanges. ETDs are standardized derivative contracts traded on platforms like futures and options exchanges.

Question 13: How are the terms of an Exchange-Traded Derivative (like size and settlement dates) decided?

A. They are customized by the individual buyer and seller.
B. They are standardized by the exchange on which they are traded.
C. They are determined by the first person who wants to trade the contract.
D. They change every day based on market demand.

Show Explanation

Correct Answer: B. They are standardized by the exchange on which they are traded. Exchanges set the standard terms for ETD contracts, such as size and settlement dates.

Question 14: How is the price of an Exchange-Traded Derivative determined?

A. It is set by the company that created the derivative.
B. It is decided through negotiation between two parties.
C. It is determined by open market forces of supply and demanD.
D. It is fixed by the government to ensure stability.

Show Explanation

Correct Answer: C. It is determined by open market forces of supply and demand. Pricing of ETDs is transparent and results from the interaction of buy and sell orders in the market.

Question 15: How is the risk of one party not fulfilling their obligation handled in Exchange-Traded Derivatives?

A. It is ignored as these are very safe investments.
B. The exchange acts as a central counterparty to all trades, reducing this risk.
C. The buyer has to trust the seller completely.
D. The government guarantees all exchange-traded derivative contracts.

Show Explanation

Correct Answer: B. The exchange acts as a central counterparty to all trades, reducing this risk. The exchange (CCP) minimizes counterparty risk in ETDs by acting as an intermediary.

Question 16: How are margin requirements managed for Exchange-Traded Derivatives?

A. Margin is only required if the trader is making a profit.
B. Margin requirements are set by the individual brokers.
C. Margin requirements are set by the exchange and collected daily based on market prices.
D. Margin is a one-time payment made at the start of the contract.

Show Explanation

Correct Answer: C. Margin requirements are set by the exchange and collected daily based on market prices. Exchanges set margin requirements for ETDs, and these are adjusted daily through a process called marked-to-market.

Question 17: What is the primary use of Exchange-Traded Derivatives?

A. For long-term savings and retirement planning.
B. For trading and trying to profit from price changes.
C. For companies to directly borrow money from the public.
D. For governments to manage their national debt.

Show Explanation

Correct Answer: B. For trading and trying to profit from price changes. ETDs are commonly used for trading and speculation, where individuals or entities aim to profit from anticipated price movements.

Question 18: How is the settlement of an Exchange-Traded Derivative usually done?

A. By physically exchanging the underlying asset.
B. Typically through a cash payment representing the net profit or loss.
C. By extending the contract for a longer perioD.
D. By donating the underlying asset to a charity.

Show Explanation

Correct Answer: B. Typically through a cash payment representing the net profit or loss. Settlement in ETDs is usually done via cash (net settlement) rather than physical delivery.

Question 19: Which type of derivatives do bank treasuries and corporations mostly use for customized hedging?

A. Exchange-Traded Futures.
B. Over-the-Counter (OTC) derivatives like forwards, options, and swaps.
C. Government-issued bonds.
D. Shares of publicly listed companies.

Show Explanation

Correct Answer: B. Over-the-Counter (OTC) derivatives like forwards, options, and swaps. Bank treasuries and corporations prefer OTC derivatives for their ability to be tailored to specific hedging needs.

Question 20: What do banks that act as market makers in OTC derivatives often use to protect themselves from risk?

A. They buy large amounts of physical gold.
B. They often use exchange-traded futures to hedge their overall risk.
C. They rely on government guarantees to cover potential losses.
D. They avoid trading in risky OTC derivatives altogether.

Show Explanation

Correct Answer: B. They often use exchange-traded futures to hedge their overall risk. Banks that facilitate OTC derivative trading often use exchange-traded futures to manage their net residual risk.

Question 21: What does “hedging” mean in the context of finance?

A. Making very risky investments for potentially high returns.
B. Entering into a transaction to reduce or eliminate an existing risk.
C. Borrowing large sums of money to invest in the market.
D. Predicting future market movements with certainty.

Show Explanation

Correct Answer: B. Entering into a transaction to reduce or eliminate an existing risk. Hedging is a strategy used to protect against potential losses by taking an offsetting position.

Question 22: What is “speculation” in financial markets?

A. The act of carefully analyzing a company’s financial statements.
B. Taking a position to profit from expected future price changes, while accepting the risk.
C. Investing in very safe and stable assets for long-term growth.
D. Following the advice of financial experts without doing your own research.

Show Explanation

Correct Answer: B. Taking a position to profit from expected future price changes, while accepting the risk. Speculation involves betting on the future direction of prices to make a profit, which inherently carries risk.

Question 23: What is the role of a “market maker”?

A. Someone who advises people on which stocks to buy.
B. A dealer who provides both buying and selling prices for an asset, ready to trade.
C. A government official who regulates the stock market.
D. A company that issues new shares to the public.

Show Explanation

Correct Answer: B. A dealer who provides both buying and selling prices for an asset, ready to trade. A market maker facilitates trading by quoting bid (buy) and ask (sell) prices.

Question 24: What is the main goal of Asset Liability Management (ALM)?

A. To maximize profits in the short term, regardless of risk.
B. To manage the risks that arise from differences in the timing or rates of assets and liabilities.
C. To ensure that a company always has more liabilities than assets.
D. To completely avoid any form of financial risk.

Show Explanation

Correct Answer: B. To manage the risks that arise from differences in the timing or rates of assets and liabilities. ALM focuses on balancing and managing the risks associated with a financial institution’s assets and liabilities.

Question 25: What does “notional amount” refer to in a derivative contract?

A. The actual profit or loss made on the contract.
B. The initial investment required to enter the contract.
C. The principal value used to calculate payments in the contract.
D. The total cost of setting up the derivative contract.

Show Explanation

Correct Answer: C. The principal value used to calculate payments in the contract. The notional amount is the reference value on which the payments in a derivative contract are based.

Question 26: What is “margin” in the context of derivative trading?

A. The profit that a trader makes on a successful trade.
B. The fee charged by the broker for executing the trade.
C. The collateral deposited to cover potential losses on open positions.
D. The total value of the assets being traded.

Show Explanation

Correct Answer: C. The collateral deposited to cover potential losses on open positions. Margin is a security deposit required to cover potential losses in derivative trading.

Question 27: What is “counterparty risk”?

A. The risk that the price of the underlying asset will move against the trader’s position.
B. The risk that the other party in a contract will fail to meet their obligations.
C. The risk that the exchange on which the derivative is traded will shut down.
D. The risk that the government will change the regulations related to derivatives.

Show Explanation

Correct Answer: B. The risk that the other party in a contract will fail to meet their obligations. Counterparty risk is the chance that the other party in a derivative contract will default.

Question 28: What does “physical delivery” mean in derivative settlement?

A. Settling the contract by making a cash payment.
B. The actual transfer of the underlying asset as specified in the contract.
C. Extending the life of the derivative contract.
D. Donating the underlying asset to a charity.

Show Explanation

Correct Answer: B. The actual transfer of the underlying asset as specified in the contract. Physical delivery involves the exchange of the actual underlying asset upon the settlement of the derivative contract.

Question 29: What is “net settlement” or “cash settlement” of a derivative contract?

A. Exchanging the full value of the underlying asset.
B. Settling the contract by paying the difference between the contract price and the market price at expiration.
C. Postponing the settlement date to a future time.
D. Agreeing to trade a different asset instead.

Show Explanation

Correct Answer: B. Settling the contract by paying the difference between the contract price and the market price at expiration. Net or cash settlement involves paying or receiving the net difference in value without the physical exchange of the underlying asset.

Question 30: What is a Forward Contract for foreign exchange?

A. It is an agreement to exchange goods between two countries.
B. It is an Over-the-Counter agreement to buy or sell a specific amount of foreign money at a set rate on a future date.
C. It is a type of loan taken in a foreign currency.
D. It is a government rule about how much foreign money people can hold.

Show Explanation

Correct Answer: B. It is an Over-the-Counter agreement to buy or sell a specific amount of foreign money at a set rate on a future date. A forward contract is a private agreement to trade a specific amount of foreign currency at a predetermined rate on a future date.

Question 31: Is it mandatory for both parties in a Forward Contract to complete the deal at the agreed future date?

A. No, either party can choose to cancel the contract if they want.
B. Yes, both the buyer and the seller are obligated to execute the contract at expiry.
C. Only the buyer has the option to complete the deal.
D. Only the seller has the option to complete the deal.

Show Explanation

Correct Answer: B. Yes, both the buyer and the seller are obligated to execute the contract at expiry. Forward contracts are binding agreements, meaning both parties must fulfill their part of the deal on the specified date.

Question 32: What is the main reason why importers use Forward Contracts for foreign exchange?

A. To earn extra interest on their money.
B. To protect themselves from the risk of changes in exchange rates when they need to pay for goods in the future.
C. To get a discount on the price of the goods they are importing.
D. To delay making payments for as long as possible.

Show Explanation

Correct Answer: B. To protect themselves from the risk of changes in exchange rates when they need to pay for goods in the future. Importers use forward contracts to hedge against the risk of the foreign currency becoming more expensive.

Question 33: What mainly determines the Forward Rate in a foreign exchange Forward Contract?

A. The current spot exchange rate only.
B. The interest rate difference between the two currencies involved.
C. The historical average of the exchange rate over the past year.
D. The expected inflation rate in the home country.

Show Explanation

Correct Answer: B. The interest rate difference between the two currencies involved. The forward rate is primarily influenced by the difference in interest rates between the two currencies.

Question 34: When does a “Forward Premium” usually exist?

A. When the forward rate is lower than the spot rate.
B. When the forward rate is the same as the spot rate.
C. When the forward rate is higher than the spot rate, typically if the foreign currency has a lower interest rate.
D. Only when the trade volume of the currency is very high.

Show Explanation

Correct Answer: C. When the forward rate is higher than the spot rate, typically if the foreign currency has a lower interest rate. A forward premium occurs when it costs more to buy the foreign currency in the future than it does now.

Question 35: What is a “Forward Discount”?

A. A reduction in the commission charged by the bank.
B. When the forward rate is higher than the spot rate.
C. When the forward rate is lower than the spot rate, often when the foreign currency has a higher interest rate.
D. A special offer for large volume trades.

Show Explanation

Correct Answer: C. When the forward rate is lower than the spot rate, often when the foreign currency has a higher interest rate. A forward discount means it costs less to buy the foreign currency in the future than it does today.

Question 36: What does a “Forward Option” or “Window Forward” allow?

A. The option to cancel the forward contract at any time.
B. Flexibility to settle the contract at any exchange rate.
C. Flexibility to settle the contract within a specific period before the final maturity date.
D. The option to trade a different currency than originally agreed.

Show Explanation

Correct Answer: C. Flexibility to settle the contract within a specific period before the final maturity date. A forward option provides a window of time before the final date within which the contract can be settled.

Question 37: What is a key advantage of using a Forward Contract?

A. It allows you to make unlimited profits if the exchange rate moves in your favor.
B. It locks in a specific exchange rate, removing uncertainty about future costs or revenues in foreign currency.
C. It gives you the option to buy or sell the currency at the best possible rate in the future.
D. It is free of any charges or fees.

Show Explanation

Correct Answer: B. It locks in a specific exchange rate, removing uncertainty about future costs or revenues in foreign currency. The main benefit is the elimination of exchange rate uncertainty.

Question 38: What is a key disadvantage of using a Forward Contract?

A. It guarantees a loss on the transaction.
B. It prevents you from benefiting if the exchange rate moves in a way that would have been favorable to you after you booked the contract.
C. It requires you to pay a very high upfront fee.
D. It is only available for very large amounts of money.

Show Explanation

Correct Answer: B. It prevents you from benefiting if the exchange rate moves in a way that would have been favorable to you after you booked the contract. By locking in a rate, you miss out on potential favorable exchange rate movements.

Question 39: What is an Option contract in finance?

A. An obligation to buy or sell an asset at a specific price on a future date.
B. A contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a fixed price on a future date.
C. An agreement to exchange goods or services at a future date.
D. A type of loan with a fixed interest rate.

Show Explanation

Correct Answer: B. A contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a fixed price on a future date. An option provides a right without an obligation to trade.

Question 40: What does a “Call Option” give the buyer the right to do?

A. The right to sell the underlying asset.
B. The right to buy the underlying asset.
C. The obligation to buy the underlying asset.
D. The obligation to sell the underlying asset.

Show Explanation

Correct Answer: B. The right to buy the underlying asset. A call option grants the holder the right to purchase the underlying asset.

Question 41: What does a “Put Option” give the buyer the right to do?

A. The right to buy the underlying asset.
B. The right to sell the underlying asset.
C. The obligation to buy the underlying asset.
D. The obligation to sell the underlying asset.

Show Explanation

Correct Answer: B. The right to sell the underlying asset. A put option grants the holder the right to sell the underlying asset.

Question 42: What is the “Strike Price” or “Exercise Price” in an option contract?

A. The price at which the option was bought.
B. The current market price of the underlying asset.
C. The pre-agreed price at which the underlying asset can be bought or sold if the option is exerciseD.
D. The price at which the option will expire if not exercised.

Show Explanation

Correct Answer: C. The pre-agreed price at which the underlying asset can be bought or sold if the option is exercised. The strike price is the fixed price for the potential transaction.

Question 43: What is the typical style of currency options in India?

A. American Style, meaning it can be exercised at any time before expiry.
B. European Style, meaning it can only be exercised on the expiry date.
C. Asian Style, meaning the exercise price is an average of prices over a perioD.
D. Bermudan Style, meaning it can be exercised on specific dates before expiry.

Show Explanation

Correct Answer: B. European Style, meaning it can only be exercised on the expiry date. In India, currency options are typically European style.

Question 44: What is the “Option Premium”?

A. The profit made if the option is exercised.
B. The price the buyer pays to the seller for the option rights.
C. The amount by which the strike price is different from the spot price.
D. The fee charged by the exchange for trading the option.

Show Explanation

Correct Answer: B. The price the buyer pays to the seller for the option rights. The option premium is the cost of buying the option.

Question 45: What are the two main components of an Option Premium?

A. Profit and Loss.
B. Buying Price and Selling Price.
C. Intrinsic Value and Time Value.
D. Spot Price and Forward Price.

Show Explanation

Correct Answer: C. Intrinsic Value and Time Value. The premium is made up of the intrinsic value and the time value.

Question 46: What is “Intrinsic Value” for a Call Option?

A. It is always equal to the strike price.
B. It is the amount by which the spot price is greater than the strike price (if positive, otherwise zero).
C. It is the time remaining until the option expires.
D. It is the price at which the option was bought.

Show Explanation

Correct Answer: B. It is the amount by which the spot price is greater than the strike price (if positive, otherwise zero). Intrinsic value for a call option exists when the current market price is above the strike price.

Question 47: What is “Time Value” in an option premium?

A. The actual profit made on the option so far.
B. The part of the premium that reflects the possibility of the option becoming profitable before expiry; it decreases as expiry approaches.
C. The initial cost of buying the underlying asset.
D. The difference between the highest and lowest price of the option.

Show Explanation

Correct Answer: B. The part of the premium that reflects the possibility of the option becoming profitable before expiry; it decreases as expiry approaches. Time value represents the potential for the option to become more valuable before it expires.

Question 48: What is an “At-the-Money (ATM)” option?

A. An option that is about to expire.
B. An option where the strike price is significantly different from the spot price.
C. An option where the strike price is approximately equal to the spot price.
D. An option that has no intrinsic value.

Show Explanation

Correct Answer: C. An option where the strike price is approximately equal to the spot price. ATM options have a strike price close to the current market price.

Question 49: What is a key advantage for the buyer of an Option contract?

A. They are guaranteed to make a profit.
B. Their potential loss is limited to the premium they paid.
C. They are obligated to buy or sell the underlying asset.
D. They can trade without any upfront cost.

Show Explanation

Correct Answer: B. Their potential loss is limited to the premium they paid. The maximum loss for an option buyer is the premium paid.

Question 50: What is a Futures Contract?

A. A private agreement between two parties to trade an asset in the future.
B. A standardized agreement, traded on an exchange, obligating the buyer/seller to transact an asset at a set price on a future date.
C. An option to buy or sell an asset at a specific price on a future date.
D. A contract to exchange interest rate payments.

Show Explanation

Correct Answer: B. A standardized agreement, traded on an exchange, obligating the buyer/seller to transact an asset at a set price on a future date. Futures contracts are standardized and traded on exchanges, creating an obligation to trade.

Question 51: Which of the following is a key characteristic of a Futures Contract?

A. Traded Over-the-Counter (OTC).
B. Terms are customized between the buyer and seller.
C. Daily settlement of gains/losses through Marked-to-Market (MTM).
D. Direct counterparty risk between the buyer and seller.

Show Explanation

Correct Answer: C. Daily settlement of gains/losses through Marked-to-Market (MTM). Futures contracts involve daily valuation and settlement of profits or losses.

Question 52: How does a Futures Contract differ from a Forward Contract in terms of where they are traded?

A. Futures are traded OTC, while Forwards are traded on an exchange.
B. Futures are traded on an exchange, while Forwards are traded Over-the-Counter (OTC).
C. Both Futures and Forwards are traded on the same exchanges.
D. Neither Futures nor Forwards are traded; they are private agreements.

Show Explanation

Correct Answer: B. Futures are traded on an exchange, while Forwards are traded Over-the-Counter (OTC). This is a primary distinction between the two types of contracts.

Question 53: Which of the following is typically more liquid: Futures Contracts or Forward Contracts?

A. Forward Contracts are typically more liquid.
B. Futures Contracts are typically more liquid.
C. Both have the same level of liquidity.
D. Liquidity depends entirely on the specific asset being traded.

Show Explanation

Correct Answer: B. Futures Contracts are typically more liquid. Due to standardization and exchange trading, futures contracts generally have higher liquidity.

Question 54: Which of the following is an example of a type of Futures Contract?

A. A private agreement to buy US Dollars for Indian Rupees in three months.
B. A standardized contract to buy a specific quantity of gold at a predetermined price on a future date, traded on an exchange.
C. An option to buy shares of a company at a specific price next month.
D. An agreement between two companies to exchange fixed and floating interest rate payments.

Show Explanation

Correct Answer: B. A standardized contract to buy a specific quantity of gold at a predetermined price on a future date, traded on an exchange. Commodity Futures are a common type of futures contract.

Question 55: How do Interest Rate Futures prices generally move in relation to interest rate changes?

A. The price moves in the same direction as interest rate changes.
B. The price moves inversely with interest rate changes.
C. The price is not affected by interest rate changes.
D. The relationship between price and interest rates is random.

Show Explanation

Correct Answer: B. The price moves inversely with interest rate changes. When interest rates rise, the value of fixed-income instruments like those underlying IRFs typically falls.

Question 56: What is “Marked-to-Market (MTM)” in the context of Futures Contracts?

A. The final settlement of the contract on the expiry date.
B. A daily process of valuing futures positions and settling gains/losses against margin accounts.
C. The initial price at which the futures contract was bought or solD.
D. The fee charged by the exchange for trading futures.

Show Explanation

Correct Answer: B. A daily process of valuing futures positions and settling gains/losses against margin accounts. MTM ensures that profits and losses are realized and settled daily.

Question 57: What is “Margin” in futures trading?

A. The total value of the assets underlying the futures contract.
B. The profit made on a successful futures trade.
C. A security deposit required to open and maintain a futures position, covering potential losses.
D. The commission paid to the broker for executing the futures trade.

Show Explanation

Correct Answer: C. A security deposit required to open and maintain a futures position, covering potential losses. Margin acts as collateral to cover potential losses in futures trading.

Question 58: What is “Basis Risk” in hedging with futures?

A. The risk of losing the entire margin amount.
B. The risk that the futures contract will expire worthless.
C. The risk that the futures price movement doesn’t perfectly match the price movement of the asset being hedgeD.
D. The risk that the exchange will default on its obligations.

Show Explanation

Correct Answer: C. The risk that the futures price movement doesn’t perfectly match the price movement of the asset being hedged. Basis risk arises from the imperfect correlation between the futures price and the spot price of the hedged asset.

Question 59: What is an Interest Rate Swap (IRS)?

A. An agreement to buy or sell a currency at a future date.
B. An Over-the-Counter contract where two parties agree to exchange interest payment streams based on a common notional amount.
C. A standardized contract to trade bonds on an exchange.
D. An option to exchange interest rates at a future point in time.

Show Explanation

Correct Answer: B. An Over-the-Counter contract where two parties agree to exchange interest payment streams based on a common notional amount. IRS involves swapping interest rate obligations.

Question 60: What is the primary purpose of an Interest Rate Swap (IRS)?

A. To exchange the principal amount of a loan between two parties.
B. To swap interest rate exposures, such as changing from a fixed rate to a floating rate.
C. To speculate on the future direction of interest rates.
D. To convert a loan from one currency to another.

Show Explanation

Correct Answer: B. To swap interest rate exposures, such as changing from a fixed rate to a floating rate. IRS allows parties to manage their interest rate risk.

Question 61: What is the “Notional Principal Amount” in an Interest Rate Swap?

A. The actual amount of money exchanged between the parties.
B. The profit or loss made on the swap transaction.
C. The reference amount used to calculate the interest payments exchanged, but it is typically not exchangeD.
D. The fee paid to the intermediary for arranging the swap.

Show Explanation

Correct Answer: C. The reference amount used to calculate the interest payments exchanged, but it is typically not exchanged. The notional principal is used only for calculation purposes.

Question 62: Which of the following is a common benchmark rate used in Interest Rate Swaps in India?

A. The London Interbank Offered Rate (LIBOR).
B. The overnight Mumbai Inter-Bank Offered Rate (O/N MIBOR).
C. The New York Prime Rate.
D. The European Central Bank’s main refinancing rate.

Show Explanation

Correct Answer: B. The overnight Mumbai Inter-Bank Offered Rate (O/N MIBOR). O/N MIBOR is a key benchmark for floating rates in Indian IRS.

Question 63: How does a Forward Rate Agreement (FRA) differ from an Interest Rate Swap (IRS)?

A. An FRA covers multiple future periods, while an IRS locks in a rate for a single future period.
B. An IRS is traded on an exchange, while an FRA is an OTC contract.
C. An FRA locks in an interest rate for a single future period, while an IRS covers multiple periods.
D. There is no difference between an FRA and an IRS.

Show Explanation

Correct Answer: C. An FRA locks in an interest rate for a single future period, while an IRS covers multiple periods. This is the key difference in their time horizon.

Question 64: What is the counterparty risk exposure in an Interest Rate Swap (IRS) primarily limited to?

A. The full notional principal amount of the swap.
B. The initial margin deposited by both parties.
C. The net difference in interest payments due between the parties.
D. The total value of the underlying assets of the parties involved.

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Correct Answer: C. The net difference in interest payments due between the parties. Counterparty risk in IRS is lower as it’s limited to the net interest payments.

Question 65: What is a common use of Interest Rate Swaps (IRS)?

A. To exchange principal amounts between two different currencies.
B. To manage interest rate risk on debt or assets.
C. To buy or sell government bonds at a future date.
D. To speculate on the movement of foreign exchange rates.

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Correct Answer: B. To manage interest rate risk on debt or assets. IRS is a primary tool for hedging interest rate exposure.

Question 66: What is a Currency Swap?

A. An agreement to buy or sell a specific amount of foreign currency at a predetermined exchange rate on a specified future date.
B. An OTC contract to exchange cash flows (principal and/or interest payments) denominated in one currency for cash flows in another currency.
C. A standardized contract traded on an exchange to buy or sell currencies at a future date.
D. An option to exchange currencies at a specific rate on a future date.

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Correct Answer: B. An OTC contract to exchange cash flows (principal and/or interest payments) denominated in one currency for cash flows in another currency. Currency swaps involve exchanging cash flows in different currencies.

Question 67: What is a common purpose of using a Currency Swap?

A. To speculate on the future movement of interest rates.
B. To hedge currency risk on foreign assets or liabilities.
C. To invest in foreign stock markets without actually exchanging currencies.
D. To avoid paying taxes on international transactions.

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Correct Answer: B. To hedge currency risk on foreign assets or liabilities. Currency swaps are often used to manage the risk of exchange rate fluctuations.

Question 68: What is a “Principal Only Swap (POS)”?

A. A currency swap where only the interest payments are exchanged.
B. A currency swap where only the principal amounts are exchanged, usually at the start and end.
C. A currency swap where both principal and interest payments are exchangeD.
D. A type of interest rate swap, not a currency swap.

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Correct Answer: B. A currency swap where only the principal amounts are exchanged, usually at the start and end. POS focuses on the exchange of the principal amounts.

Question 69: What is a common use of Currency Swaps in India?

A. To trade in the domestic stock market using foreign currency.
B. Converting foreign currency debt (like External Commercial Borrowings – ECB) into a Rupee liability.
C. To invest in foreign government bonds without currency risk.
D. To facilitate international trade payments directly without using banks.

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Correct Answer: B. Converting foreign currency debt (like External Commercial Borrowings – ECB) into a Rupee liability. This helps Indian entities manage the currency risk associated with foreign debt.

Question 70: Before 1998, what type of derivative contracts were mainly used in India?

A. Interest Rate Swaps.
B. Currency Options.
C. Rupee Forward Contracts.
D. Equity Futures.

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Correct Answer: C. Rupee Forward Contracts. Before 1998, the Indian derivative market primarily involved agreements to buy or sell Rupees at a future date.

Question 71: In what year did the Reserve Bank of India (RBI) allow Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA) in India?

A. 1995
B. 2000
C. 1999
D. 2005

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Correct Answer: C. 1999. The RBI permitted the use of IRS and FRAs starting in 1999.

Question 72: According to RBI guidelines, what is the permitted use of “plain vanilla” Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA) for corporations?

A. For any type of investment or trading activity.
B. Strictly for hedging their actual underlying financial exposures.
C. For lending money to other companies.
D. For speculating on interest rate movements.

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Correct Answer: B. Strictly for hedging their actual underlying financial exposures. Corporations in India are allowed to use IRS/FRA only to protect themselves from existing financial risks.

Question 73: Which entities in India are allowed by the RBI to use Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA) for both hedging and market-making (trading)?

A. Only individual investors.
B. Only foreign companies operating in India.
C. Banks, Primary Dealers (PDs), and Financial Institutions (FIs).
D. All companies listed on the stock exchange.

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Correct Answer: C. Banks, Primary Dealers (PDs), and Financial Institutions (FIs). These entities have broader permissions for using IRS/FRA compared to corporations.

Question 74: What is the International Swaps and Derivatives Association (ISDA) Master Agreement?

A. A set of rules made by the Indian government for derivative trading.
B. A mandatory standardized legal agreement used for derivative transactions between different parties.
C. A license required to trade derivatives in India.
D. A type of derivative contract itself.

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Correct Answer: B. A mandatory standardized legal agreement used for derivative transactions between different parties. The ISDA Master Agreement provides a common legal framework for derivative trades.

Question 75: What is the correct order of the documentation hierarchy for derivative transactions under the ISDA framework?

A. ISDA Master Agreement, Schedule, Trade Confirmation.
B. Schedule, Trade Confirmation, ISDA Master Agreement.
C. Trade Confirmation, Schedule, ISDA Master Agreement.
D. Trade Confirmation, ISDA Master Agreement, Schedule.

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Correct Answer: C. Trade Confirmation, Schedule, ISDA Master Agreement. The Trade Confirmation details the specific transaction, the Schedule customizes the Master Agreement, and the Master Agreement provides the overarching legal terms.

Question 76: What is the Mumbai Interbank Forward Outright Rate (MIFOR)?

A. The interest rate charged by the RBI to commercial banks.
B. A key benchmark rate in India, historically based on USD LIBOR and forwards.
C. The exchange rate between the US Dollar and the Indian Rupee.
D. The rate at which banks lend money to each other overnight.

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Correct Answer: B. A key benchmark rate in India, historically based on USD LIBOR and forwards. MIFOR was an important benchmark for interest rates, though its use is now restricted.

Question 77: Which organization publishes the Mumbai Interbank Forward Outright Rate (MIFOR)?

A. Reserve Bank of India (RBI).
B. Securities and Exchange Board of India (SEBI).
C. Financial Benchmarks India Pvt Ltd (FBIL).
D. Clearing Corporation of India Ltd. (CCIL).

Show Explanation

Correct Answer: C. Financial Benchmarks India Pvt Ltd (FBIL). FBIL is responsible for publishing key financial benchmarks in India, including MIFOR.

Question 78: Where must most inter-bank Over-the-Counter (OTC) foreign exchange (FX) and interest rate derivatives be reported in India?

A. To the Reserve Bank of India (RBI) directly.
B. To the Securities and Exchange Board of India (SEBI).
C. To the Clearing Corporation of India LtD. (CCIL) platform.
D. To the Financial Benchmarks India Pvt Ltd (FBIL).

Show Explanation

Correct Answer: C. To the Clearing Corporation of India Ltd. (CCIL) platform. Reporting to CCIL enhances transparency and reduces systemic risk.

Question 79: When were USD Rupee Options introduced in the Over-the-Counter (OTC) market in India?

A. June 2010
B. January 2000
C. June 2003
D. December 2005

Show Explanation

Correct Answer: C. June 2003. OTC USD Rupee options became available in India in June 2003.

Question 80: Initially, what was the permitted use of Over-the-Counter (OTC) USD Rupee Options in India?

A. For any type of trading or investment.
B. Only for hedging existing foreign exchange exposures.
C. For lending and borrowing in foreign currency.
D. For speculating on the USD/INR exchange rate.

Show Explanation

Correct Answer: B. Only for hedging existing foreign exchange exposures. Initially, the use of these options was restricted to managing currency risk.

Question 81: What are Exchange Traded Currency Derivatives (ETCDs)?

A. Privately negotiated currency option contracts.
B. Standardized, plain vanilla currency options traded on recognized stock exchanges.
C. Complex financial products involving multiple currencies.
D. Currency futures contracts traded on commodity exchanges.

Show Explanation

Correct Answer: B. Standardized, plain vanilla currency options traded on recognized stock exchanges. ETCDs offer a regulated platform for trading currency options.

Question 82: What is the minimum Net Worth required for a bank (AD Cat-1) to be eligible for trading Exchange Traded Currency Derivatives (ETCDs)?

A. ₹100 Crore
B. ₹250 Crore
C. ₹500 Crore
D. ₹1000 Crore

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Correct Answer: C. ₹500 Crore. Banks need to meet this minimum net worth criterion to trade ETCDs.

Question 83: What is the minimum Capital to Risk-Weighted Assets Ratio (CRAR) required for a bank (AD Cat-1) to trade Exchange Traded Currency Derivatives (ETCDs)?

A. 8%
B. 9%
C. 10%
D. 12%

Show Explanation

Correct Answer: C. 10%. Banks must maintain this minimum CRAR to be eligible for ETCD trading.

Question 84: What is the maximum Net Non-Performing Assets (NPA) percentage allowed for a bank (AD Cat-1) to trade Exchange Traded Currency Derivatives (ETCDs)?

A. ≤ 5%
B. ≤ 4%
C. ≤ 3%
D. ≤ 2%

Show Explanation

Correct Answer: C. ≤ 3%. Banks with NPAs exceeding this limit may face restrictions on ETCD trading.

Question 85: According to RBI guidelines for hedging with USD Rupee Options, is cancellation of contracts allowed?

A. No, once a hedging contract is booked, it cannot be cancelled under any circumstances.
B. Yes, cancellation is generally allowed for hedging transactions.
C. Cancellation is only allowed with a penalty.
D. Cancellation is only allowed for very small contract sizes.

Show Explanation

Correct Answer: B. Yes, cancellation is generally allowed for hedging transactions. This provides flexibility for businesses managing their currency risk.

Question 86: What is generally the rule regarding rebooking of cancelled hedging contracts for certain underlying exposures like loans?

A. Rebooking is freely allowed without any restrictions.
B. Rebooking is generally restricted to prevent speculative activities.
C. Rebooking is allowed only after a waiting period of one month.
D. Rebooking is subject to approval from the RBI.

Show Explanation

Correct Answer: B. Rebooking is generally restricted to prevent speculative activities. This rule aims to ensure that hedging is genuinely related to underlying exposures.

Question 87: What is required for trading book positions in USD Rupee Options in terms of valuation?

A. Valuation is done only at the time of settlement.
B. Daily Mark-to-Market (MTM) valuation is mandatory.
C. Valuation is done based on historical cost.
D. Valuation is not required for trading book positions.

Show Explanation

Correct Answer: B. Daily Mark-to-Market (MTM) valuation is mandatory. This ensures that the value of trading positions reflects current market prices.

Question 88: What was a key reason for the RBI to issue guidelines on structured products involving derivatives after 2005?

A. To encourage more complex derivative trading in India.
B. Due to mis-selling of complex derivatives that led to significant financial losses for corporations.
C. To simplify the process of trading derivatives for retail investors.
D. Because there was a shortage of derivative products available in the market.

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Correct Answer: B. Due to mis-selling of complex derivatives that led to significant financial losses for corporations. The RBI responded to these issues by implementing stricter guidelines.

Question 89: What did the RBI guidelines of 2007 and 2011 mandate for corporates using derivatives?

A. They were allowed to trade in any type of derivative without restrictions.
B. They were required to have Board-approved risk policies for using derivatives.
C. They were encouraged to speculate more actively in the derivatives market.
D. They were prohibited from using derivatives altogether.

Show Explanation

Correct Answer: B. They were required to have Board-approved risk policies for using derivatives. This aimed to ensure responsible use of these financial instruments.

Question 90: What type of cross-currency derivative contracts can residents and Foreign Portfolio Investors (FPIs) trade in India without needing an underlying exposure?

A. Any type of cross-currency derivative contract.
B. Only Over-the-Counter (OTC) forward contracts.
C. Exchange-traded futures and options on specific major pairs (like EUR-USD) and Rupee pairs (like EUR-INR).
D. Only interest rate swaps involving foreign currencies.

Show Explanation

Correct Answer: C. Exchange-traded futures and options on specific major pairs (like EUR-USD) and Rupee pairs (like EUR-INR). This is an exception to the general hedging rule for these specific contracts.

Question 91: When were Interest Rate Options (IROs) introduced in India?

A. 2010
B. 2015
C. 2017
D. 2020

Show Explanation

Correct Answer: C. 2017. IROs were introduced in the Indian market in 2017.

Question 92: What is the permitted use of Interest Rate Options (IROs) according to RBI guidelines?

A. Only for speculation on interest rate movements.
B. Only for hedging individual loan exposures.
C. For balance sheet management and market-making activities.
D. Only for trading between banks and the RBI.

Show Explanation

Correct Answer: C. For balance sheet management and market-making activities. IROs provide tools for managing interest rate risk and facilitating market activity.

Question 93: What style of Interest Rate Options (IROs) are permitted in India?

A. American style.
B. European style.
C. Asian style.
D. Bermudan style.

Show Explanation

Correct Answer: B. European style. This means the options can only be exercised on the expiry date.

Question 94: What is the role of Financial Benchmarks India Pvt Ltd (FBIL)?

A. To regulate the trading of derivatives in India.
B. To provide a platform for trading government securities.
C. To administer major Indian financial benchmarks, including developing methodology and publishing rates.
D. To act as a clearing house for derivative transactions.

Show Explanation

Correct Answer: C. To administer major Indian financial benchmarks, including developing methodology and publishing rates. FBIL ensures the integrity and robustness of key financial benchmarks in India.