Question

1. Credit default swaps contributed to the crisis in all the following reasons except:

a. Financial institutions relied heavily on credit default swaps to protect themselves from default risk.

b. Credit defaults swaps relaxed the lending standards of banks.

c. Banks used credit default swaps because they were eager to sell them to unwitting consumers.

d. All of the above are true.

2. You are the buyer of a call option which expires today. The call premium is $0.75 and the exercise price is $13.50. The underlying stock price is 12.50. What is your profit or loss?

a. Gain $75

b. Gain $100

c. Loss $75

d. Loss $25

e. None of the above.

Answer 1

Answer to Question no 1

--- Option 1 is true since over reliance on any particular instrument could always spell doom for any organisation. Financial institutions relying heavily on CDS could very well contribute to any crisis.

--- Option 2 is true as well. The very availability of a product called Credit Default Swaps for insuring any default being occurred could obviously make financial institutions be lackadaisical on their lending approach. There could be poor to average lending approach from banks due to the availability of a fall back mechanism in the form of CDS.  

--- Option 3 is False since CDS is not like a normal loan product that can be sold by pushing into the market. It can be sold only to those who would require a CDS in particular for any of their sticky exposure.

Answer to Question no 2

--- The premium paid is $0.75 and the strike price is $13.50. This means that the break even price for the call option buyer is $14.25. The current underlying stock price is $ 12.50 indicating a loss if $1.75 per share. Assuming one lot size is 100 shares, 100*1.75 would amount to a loss of $175. Hence the answer is e. None of the above.