IMC Financial Analysis & Derivatives 1 — Questions and Answers
Question 1: What does the Price-to-Earnings (P/E) ratio measure?
- The profitability of a company relative to its assets
- The market price of a share divided by earnings per share, indicating how much investors pay for each pound of earnings (Correct answer)
- The ratio of dividends paid to total earnings
- The ratio of a company's market value to its book value
Correct answer: The market price of a share divided by earnings per share, indicating how much investors pay for each pound of earnings
The P/E ratio = Share Price / Earnings Per Share. It indicates how much investors are willing to pay for each pound of earnings, reflecting growth expectations and risk. A high P/E may indicate growth expectations or overvaluation; a low P/E may indicate value or low growth.
Question 2: What is 'discounted cash flow' (DCF) analysis?
- Analysis of a company's historical cash expenditure
- A valuation method that estimates the present value of future expected cash flows using an appropriate discount rate (Correct answer)
- A method for calculating a bond's current yield
- An analysis of management fees charged by investment funds
Correct answer: A valuation method that estimates the present value of future expected cash flows using an appropriate discount rate
DCF analysis values an asset by projecting its future cash flows and discounting them back to present value using a discount rate that reflects the time value of money and risk. The intrinsic value = sum of discounted future cash flows.
Question 3: What is a 'forward contract' in derivatives?
- An agreement to buy or sell an asset in the future at a price agreed today, traded over-the-counter (OTC) (Correct answer)
- A contract to buy shares on the current day's close
- An agreement to lend money at a future date
- A regulatory contract for forward-looking risk reporting
Correct answer: An agreement to buy or sell an asset in the future at a price agreed today, traded over-the-counter (OTC)
A forward contract is a binding OTC agreement between two parties to buy or sell an asset at a specified price on a future date. Unlike futures, forwards are customised, not standardised, and are not exchange-traded, creating counterparty risk.
Question 4: What is the key difference between a 'futures contract' and a 'forward contract'?
- Futures have no expiry date; forwards expire daily
- Futures are standardised, exchange-traded, and cleared centrally; forwards are customised OTC contracts with counterparty risk (Correct answer)
- Futures are only for commodities; forwards are only for currencies
- Futures require full upfront payment; forwards require no upfront payment
Correct answer: Futures are standardised, exchange-traded, and cleared centrally; forwards are customised OTC contracts with counterparty risk
Futures are standardised contracts traded on exchanges with daily mark-to-market settlement and central clearing through a CCP, virtually eliminating counterparty risk. Forwards are customised, OTC bilateral agreements with counterparty risk but greater flexibility.
Question 5: What is a 'call option' and what is the maximum loss for the buyer?
- The right to sell an asset at a strike price; maximum loss is unlimited
- The right to buy an asset at a strike price before expiry; maximum loss is the premium paid (Correct answer)
- The obligation to buy an asset; maximum loss is the full asset value
- The right to call in a loan; maximum loss is the interest foregone
Correct answer: The right to buy an asset at a strike price before expiry; maximum loss is the premium paid
A call option gives the holder the right (but not the obligation) to buy an underlying asset at the strike price before or at expiry. The maximum loss for a call buyer is the premium paid, while the potential profit is theoretically unlimited if the asset price rises.
Question 6: What is a 'put option' and when would an investor buy one?
- An option to put money into a savings account
- The right to sell an asset at a strike price before expiry; bought to profit from or hedge against a price fall (Correct answer)
- An obligation to sell an asset
- An option that pays out when volatility falls
Correct answer: The right to sell an asset at a strike price before expiry; bought to profit from or hedge against a price fall
A put option gives the holder the right to sell an underlying asset at the strike price before or at expiry. Investors buy puts to profit from anticipated price falls (speculation) or to protect an existing long position against downside losses (hedging).
IMC Financial Analysis & Derivatives 1
What does the Price-to-Earnings (P/E) ratio measure?