Common Mistakes to Avoid
Watch out for these exam traps that candidates frequently miss on Types of Derivative Securities questions:
Confusing options (right) vs futures (obligation)
Mixing up exchange-traded vs OTC derivatives
Forgetting futures are standardized, forwards are customized
Sample Practice Questions
An investor who purchases a call option has which of the following rights or obligations?
A is correct. A call option buyer pays a premium to acquire the right (not obligation) to purchase the underlying security at a specified strike price before expiration. The buyer can choose whether or not to exercise this right based on market conditions.
B (the obligation to buy) describes the position of a call option seller (writer), not the buyer. C (the right to sell) describes a put option buyer. D (the obligation to sell) describes a put option seller.
Understanding the fundamental distinction between buying and selling options is tested frequently on the Series 65. Remember that option buyers pay premiums to acquire rights, while option sellers receive premiums and take on obligations. This concept appears in multiple contexts, including covered calls, protective puts, and complex option strategies. The key word "right" versus "obligation" often distinguishes correct answers from distractors.
Which of the following best describes a put option?
C is correct. A put option gives the buyer the right (not obligation) to sell the underlying security at the strike price before expiration. Put buyers typically profit when the underlying security decreases in value below the strike price.
A (the right to buy) defines a call option, not a put option. B (the obligation to buy) describes a short put position or certain features of futures contracts. D (the obligation to sell) describes a short call position, not a long put.
Put options are commonly tested on the Series 65, especially in the context of portfolio protection strategies like protective puts. Understanding that puts give the right to sell (while calls give the right to buy) is fundamental to answering questions about hedging strategies, breakeven calculations, and risk management. This distinction also helps when evaluating whether an investor should use puts versus other hedging methods.
What is the primary difference between futures contracts and options contracts?
A is correct. The fundamental distinction is that futures contracts create binding obligations for both the buyer and seller to complete the transaction at the agreed price on the settlement date. In contrast, option buyers have the right but not the obligation to exercise, while only option sellers have obligations.
B (trading venues) is incorrect because both futures and options trade on organized exchanges. C (expiration timing) is inaccurate as both have various expiration cycles. D (margin) is misleading because while futures do require margin, option buyers pay premiums in full but option sellers also face margin requirements.
This distinction between rights and obligations is one of the most commonly tested concepts on the Series 65 exam. It affects risk profiles, suitability determinations, and hedging strategies. Understanding this difference helps advisers determine when futures versus options are appropriate for client portfolios. Questions often test whether candidates can identify the obligation nature of futures when evaluating risk exposure.
Which of the following characteristics distinguishes forward contracts from futures contracts?
C is correct. Forward contracts are customized, privately negotiated agreements that trade in the over-the-counter (OTC) market. This customization allows parties to tailor contract terms (amount, delivery date, quality specifications) to their specific needs, but it also introduces counterparty risk since there is no clearinghouse guarantee.
A (standardization) is backwards. Futures are standardized, not forwards. B (trading venues) is reversed. Futures trade on exchanges, while forwards trade OTC. D (guarantees) is also reversed. Futures have clearinghouse guarantees that eliminate counterparty risk, while forwards carry counterparty risk.
The Series 65 exam frequently tests the distinction between exchange-traded and OTC derivatives. Understanding that forwards are customized OTC instruments helps advisers assess counterparty risk and liquidity concerns. This concept often appears in questions about derivative suitability, especially when comparing hedging alternatives for institutional clients. Remember: futures are standardized and exchange-traded, forwards are customized and OTC.
An interest rate swap most commonly involves the exchange of which of the following?
D is correct. Interest rate swaps are agreements to exchange fixed-rate interest payments for floating-rate interest payments based on a notional principal amount. The notional principal itself is not actually exchanged. Interest rate swaps are the most common type of derivative by notional value and are used to manage interest rate risk exposure.
A (currencies) describes currency swaps, not interest rate swaps. B (stocks for bonds) is not a swap transaction. C (call for put options) does not describe any standard swap arrangement. These are all plausible distractors for candidates unfamiliar with swap mechanics.
Interest rate swaps appear on the Series 65 exam in contexts involving institutional risk management and derivatives characteristics. Understanding that swaps exchange payment streams (not principal) is essential for evaluating their risks and uses. This concept connects to fixed income topics, particularly duration management and interest rate risk. Swaps are OTC derivatives with counterparty risk, which distinguishes them from exchange-traded futures.
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Access Free BetaAll of the following are characteristics of exchange-traded derivatives EXCEPT
C is correct. Exchange-traded derivatives (such as listed options and futures) have standardized contract terms, not customized terms. Standardization is a defining feature that enables exchange trading and provides liquidity. Customization is a characteristic of over-the-counter (OTC) derivatives like forwards and swaps.
A (standardized terms), B (clearinghouse guarantee), and D (daily mark-to-market) are all standard features of exchange-traded derivatives. These characteristics reduce counterparty risk and increase transparency compared to OTC derivatives.
The Series 65 exam tests the distinction between exchange-traded and OTC derivatives across multiple questions. Understanding that exchange-traded instruments are standardized (while OTC instruments are customized) helps determine suitability, liquidity, and risk characteristics. This negative stem question format is common on the exam, so practice identifying the exception among otherwise correct statements. Always read carefully when you see EXCEPT, NOT, or LEAST.
American-style options differ from European-style options in that American options:
B is correct. American-style options provide the holder with flexibility to exercise at any time before the expiration date. This early exercise feature gives American options potentially more value than European options, though early exercise is often not economically optimal due to time value considerations.
A (only at expiration) describes European-style options, not American options. C (geographic trading) is misleading because the names American and European refer to exercise styles, not where the options are traded. D (expiration periods) is incorrect because exercise style does not determine expiration length. LEAPS (Long-term Equity Anticipation Securities) can extend up to three years and are always American style.
Understanding exercise styles appears on the Series 65 when discussing option characteristics and valuation. Most equity options in the U.S. are American style, while many index options are European style. This distinction affects strategic decisions like early exercise considerations and impacts option pricing models. The exam may test whether candidates understand that American options offer more flexibility but that early exercise often forfeits remaining time value.
Which of the following best describes a warrant?
D is correct. Warrants are long-term securities (often lasting several years) that give the holder the right to purchase stock at a specified exercise price. At issuance, the exercise price is typically set above the current market price. Warrants are often attached to bond offerings as a "sweetener" to make the bonds more attractive to investors.
A (short-term, below market) describes subscription rights, not warrants. Rights are typically short-term (30 to 45 days) with exercise prices below current market value. B (obligation to buy) describes futures or similar derivatives, not warrants which convey rights. C (standardized exchange-traded) describes futures contracts, though some warrants do trade on exchanges.
Warrants appear on the Series 65 in questions about equity securities and corporate financing. Understanding the distinction between warrants (long-term, above market at issuance) and rights (short-term, below market) is frequently tested. This concept connects to topics about dilution, corporate actions, and how companies raise capital. Warrants can be detached and traded separately from the securities they were issued with, unlike conversion features.
A currency swap would most likely be used by a corporation to:
D is correct. Currency swaps involve the exchange of principal and interest payments denominated in different currencies. Corporations use currency swaps to manage foreign exchange risk, particularly when they have revenues or expenses in multiple currencies. These swaps allow companies to match their cash flows with their currency exposures.
A (interest rate hedging on domestic debt) describes the purpose of interest rate swaps, not currency swaps. B (equity speculation) is unrelated to swap instruments, which focus on managing interest rate and currency risks. C (income from stock positions) describes covered call strategies, not currency swap applications.
Currency swaps appear on the Series 65 exam in the context of derivative types and international investing. Understanding that currency swaps manage foreign exchange risk (while interest rate swaps manage rate risk) helps distinguish between swap types. This concept connects to topics about multinational corporations, international portfolios, and currency risk management. Swaps are OTC derivatives with counterparty risk, an important consideration for suitability analysis.
Which of the following derivatives would have the MOST counterparty risk?
B is correct. Forward contracts are customized, over-the-counter agreements between two parties without clearinghouse guarantees. This means each party faces the risk that the counterparty may default on its obligations. OTC derivatives like forwards and swaps carry significant counterparty risk, which is a key distinction from exchange-traded derivatives.
A (listed options) and C (futures) both have clearinghouse guarantees that effectively eliminate counterparty risk through daily mark-to-market settlements and margin requirements. D (LEAPS) are exchange-traded long-term options with the same clearinghouse protections as standard options. All three are incorrect because they have minimal counterparty risk compared to OTC instruments.
Counterparty risk is a critical concept tested on the Series 65, particularly when comparing derivative types. Understanding that OTC derivatives (forwards, swaps) carry counterparty risk while exchange-traded instruments (futures, listed options) have clearinghouse guarantees affects suitability recommendations and risk assessment. This concept appears in questions about credit risk, derivative characteristics, and institutional portfolio management. Remember: exchange-traded means clearinghouse protection, OTC means counterparty risk.
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