Deck 26: Managing Risk

Question 1

The term "derivatives" refers to

A)forwards and futures.
B)forwards, futures, and swaps.
C)swaps and options.
D)forwards, futures, swaps, and options.

Answer 1

forwards, futures, swaps, and options.

Question 2

Insurance companies, by issuing Cat bonds (catastrophe bonds), share their risks with

A)the government.
B)other insurance companies.
C)bond investors.
D)the government and other insurance companies.

Answer 2

bond investors.

Question 3

The following are sensible reasons for a firm to engage in hedge transactions:
I.to reduce the risk of financial distress;
II.to reduce the fluctuations in its income;
III.to mitigate agency costs

A)I only
B)I and II only
C)I, II, and III
D)II and III only

Answer 3

I, II, and III

Question 4

Generally, hedging transactions are

A)negative NPV transactions.
B)positive NPV transactions.
C)zero-NPV transactions.
D)None of these answers are correct.

Question 5

Insurance companies have some advantages in bearing risk. These include
I.superior ability to estimate the probability of loss;
II.extensive experience and knowledge about how to reduce the risk of a loss;
III.the ability to pool risks and thereby gain from diversification;
IV.insurance companies cannot diversify away market or macroeconomic risks

A)I, II, and III only
B)II only
C)III only
D)IV only

Question 6

If you sold a wheat futures contract for $3.75 per bushel and the contract ended at $3.60, what is your profit per bushel? (Ignore transaction costs.)

A)−$3.60
B)$0.15
C)$3.60
D)−$0.15

Question 7

A derivative is a financial instrument whose value is determined by

A)a regulatory body such as the FTC.
B)the value of an underlying asset.
C)hedging a risk.
D)speculation.

Question 8

In addition to bearing risk, insurance companies also bear

A)administrative costs.
B)moral hazard costs.
C)adverse selection costs.
D)administrative costs, moral hazard costs, and adverse selection costs.

Question 9

A type of risk peculiar to a forward contract is called

A)market risk.
B)duration risk.
C)currency risk.
D)counterparty risk.

Question 10

A risk manager should address which of the following considerations?
I.The firm needs to understand the major risks and consequences that the company faces.
II.The firm needs to determine if it is being paid for any particular risk.
III.The firm should simply view risks as external factors beyond the firm's control.
IV.The firm should know how to control a particular risk.

A)I only
B)I and II only
C)I, II, and IV only
D)III only

Question 11

The seller of a forward contract agrees to

A)deliver a product at a later date for a price set today.
B)receive a product at a later date at the price on that later date.
C)receive a product at a later date for a price set today.
D)deliver a product at a later date for a price set on that later date.

Question 12

When a firm hedges a risk, it

A)eliminates the risk.
B)transfers the risk to someone else.
C)makes the government assume the risk.
D)increases the risk.

Question 13

Insurance companies face the following problem(s):

A)administrative costs.
B)adverse selection.
C)moral hazard.
D)All of these answers are correct.

Question 14

Which of the following derivative contract features does not reduce counterparty risk?

A)Flexible forward contracts
B)Standardized exchange-listed contracts
C)Requirements to post margin
D)Requirement to trade via a clearinghouse

Question 15

Which of the following statements about forwards, futures, and options is correct?

A)Forward contracts and futures contracts are economically similar, but vary greatly in how they are traded.
B)Futures contracts and options contracts are economically similar, but vary greatly in how they are traded.
C)Forward contracts and options contracts are economically similar, but vary greatly in how they are traded.
D)Forward contracts, futures contracts, and options contracts are all economically similar, but vary greatly in how they are traded.

Question 16

Your firm operates an oil refinery and is therefore naturally short on crude oil. You buy offsetting oil market futures to hedge your natural position. Shortly thereafter, local pipelines were damaged in a recent earthquake, leaving you with the highest local crude oil prices in decades. Simultaneously, unexpectedly high recent production from Mexico, Brazil, and the Baltic Sea has driven down the global price of crude and your financial hedge has lost you millions. You have fallen victim to what kind of risk?

A)Counterparty risk
B)Basis risk
C)Market risk
D)Political risk

Question 17

One can describe a forward contract as agreeing today to buy a product

A)at a later date at a price to be set in the future.
B)today at its current price.
C)at a later date at a price set today.
D)if and only if its price rises above its exercise price.

Question 18

A derivative contract is transacted between a hedger and a speculator. What is the impact of the transaction on the risk profile of these two parties?

A)It increases the risk to both parties.
B)It decreases risk in both cases.
C)It increases risk of the hedger and decreases risk of the speculator.
D)It reduces the risk of the hedger and increases the risk of the speculator.

Question 19

When a standardized forward contract is traded on an exchange, it becomes a(n)

A)forward contract.
B)futures contract.
C)options contract.
D)swap contract.

Question 20

The price for immediate delivery of a commodity is called the

A)forward price.
B)exercise price.
C)spot price.
D)impact price.

Question 21

The relationship between the spot and futures prices of financial futures is given by

A)[Futures price] = Spot price × (1 + r_f)^t (where r_f = risk-free rate).
B)[Futures price] = Spot price × (1 + r_f − y)^t (where y = dividend yield or interest rate).
C)[Futures price] = Spot price × (1 + r_m)^t (where r_m = market rate of return).
D)[Futures price] = Spot price × (1 + r_m − r_f)^t.

Question 22

A financial institution can hedge its interest rate risk by

A)matching the duration of its assets weighted by the book value of its assets to the duration of its liabilities weighted by the book value of its liabilities.
B)setting the duration of its assets equal to half that of the duration of its liabilities.
C)matching the duration of its assets weighted by the market value of its assets with the duration of its liabilities weighted by the market value of its liabilities.
D)setting the duration of its assets weighted by the market value of its assets to one-half that of the duration of the liabilities weighted by the market value of the liabilities.

Question 23

Suppose that the current level of the Standard & Poor's Index is 500. The prospective dividend yield on S&P 500 stocks is 2 percent, and the risk-free interest rate is 6 percent. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.)

A)530
B)520
C)540
D)560

Question 24

Suppose that the current level of the Standard and Poor's Index is 950. The prospective dividend yield on S&P 500 stocks is 3 percent, and the risk-free interest rate is 5 percent. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.)

A)969
B)998
C)979
D)1,026

Question 25

If the one-year spot interest rate is 8 percent and the two-year spot interest rate is 9 percent, calculate the one-year forward interest rate one year from today.

A)10 percent
B)10.5 percent
C)11 percent
D)11.5 percent

Question 26

First National Bank recently made a five-year $100 million fixed-rate loan at 10 percent. Annual interest payments are $10 million, and all principal will be repaid in year 5. The bank wants to swap the fixed interest payment into floating-rate payments. If the bank could borrow at a fixed rate of 8 percent for five years, what is the notional principal of the swap?

A)$80 million
B)$100 million
C)$125 million
D)$180 million

Question 27

On $10 million of loans, Firm A is paying a fixed $700,000 in interest payments while Firm B is paying LIBOR plus 50 basis points. The current LIBOR rate is 6.25 percent. Firms A and B have agreed to swap interest payments. How much will be paid to which firm this year?

A)A pays $750,000 to Firm B.
B)B pays $25,000 to Firm A.
C)B pays $50,000 to Firm A.
D)A pays $25,000 to Firm B.

Question 28

If the one-year spot interest rate is 6 percent and the two-year spot interest rate is 7 percent, calculate the one-year forward interest rate one year from today.

A)6.5 percent
B)7 percent
C)7.5 percent
D)8 percent

Question 29

Third National Bank has made a 10-year, $25 million fixed-rate loan at 12 percent. Annual interest payments are $3 million, and all principal will be repaid in year 10. The bank wants to swap the fixed interest payments into floating-rate payments. If the bank could borrow at a fixed rate of 10 percent for 10 years, what is the notional principal of the swap?

A)$40 million
B)$20 million
C)$25 million
D)$30 million

Question 30

Suppose that you buy $1 million worth of euro currency futures contracts. You buy the contract at a price of $1.3468/€ (i.e., you commit to pay $1,000,000 × $1.3468 = $1,346,800 when the contract matures). Over the next four days the contract closes at the following prices: $1.3465/€, $1.3443/€, $1.3434/€, and $1.3534/€. What would be your payments to, or withdrawals from, the margin account?

A)−$500, −$1,800, −$1,100, +$10,000
B)−$300, −$2,200, −$900, +$10,000
C)+$300, +$2,200, +$900, −$10,000
D)None of these answers are correct.

Question 31

Suppose that you sold a futures contract for $3.75 per bushel and the contract ended at $3.60 after several days of closing prices of $3.80, $3.70, $3.65, $3.70, $3.65, and $3.60. What would the mark to market sequence be? (Cash flow per bushel, in $.)

A)−0.05, 0.10, 0.05, −0.05, 0.05, 0.05
B)0.05, −0.10, −0.05, 0.05, −0.05, −0.05
C)−0.05, 0.05, 0.10, 0.05, −0.09, −0.15
D)0.05, −0.05, −0.10, −0.05, −0.09, −0.015

Question 32

Suppose that the current level of the S&P 500 Index is 1,100. The prospective dividend yield is 3 percent, and the current risk-free interest rate is 7 percent. What is the value of a one-year futures contract on the index? (Assume all dividends are paid at the end of the year.)

A)1,056
B)1,144
C)1,210
D)995

Question 33

A forward interest rate contract is called a(n)

A)interest rate options agreement.
B)forward rate agreement.
C)futures rate agreement.
D)None of these answers are correct.

Question 34

Which of the following players would require a put option in order to hedge their natural position in the market?

A)A farmer who buys corn to feed his livestock
B)A farmer who sells peanuts to a chocolatier
C)A farmer who has financed his land with a floating rate mortgage
D)A miller who buys wheat from a farmer

Question 35

Suppose you borrow $95.24 for one year at 5 percent and invest $95.24 for two years at 7 percent. For the time period beginning one year from today, you have

A)borrowed at 7 percent.
B)invested at 7 percent.
C)borrowed at 9 percent.
D)invested at 9 percent.

Question 36

In a "total return swap," the underlying asset(s)might be a

A)common stock and loan.
B)common stock, loan, and commodity.
C)common stock, loan, commodity, and market index.
D)market index.

Question 37

The spot price of wheat is $2.90/bushel. The one-year futures price is $3/bushel. If the risk-free rate is 5 percent, calculate the net convenience yield.

A)−0.0160
B)0.0160
C)+0.0345
D)0.0450

Question 38

A firm owns an asset A and it wants to hedge against changes in the value of A by making an offsetting sale of asset B. The firm minimizes risk by

A)selling the same number of units of B as assets of A.
B)selling hedge ratio (delta)number of units of B.
C)selling the reciprocal of hedge ratio number of units of B.
D)buying the same number of units of B as assets of A.

Question 39

Hedging contracts on a futures exchange eliminates

A)market risk.
B)counterparty risk.
C)default risk.
D)currency risk.

Question 40

The spot price for home heating oil is $0.55 per gallon. The futures price for one year from now is $0.57. If the risk-free rate is 6 percent per year, what is the net convenience yield?

A)0.0411
B)0.0364
C)0.0236
D)0.0440

Question 41

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one-year loan is 7 percent and a two-year loan is 8 percent, it should quote 7.5 percent, which is the average of the two rates.

Question 42

The hedge ratio or delta measures the sensitivity of the value of one asset relative to the value of another asset.

Question 43

Disadvantages faced by insurance companies in bearing risk include administrative costs, adverse selection, and moral hazard.

Question 44

What are the four basic types of contracts or instruments used in financial risk management?

Question 45

"Mark to market" means that, each day, any profits or losses are calculated and the trader's margin account is adjusted accordingly.

Question 46

Briefly explain the term derivative.

Question 47

For financial futures, Futures price = (spot price)/(1 + r_f - y)^t.

Question 48

For commodity futures: Net convenience yield = (convenience yield − storage costs).

Question 49

As a commodity futures contract nears expiration, the futures price converges to the spot market price for that commodity.

Question 50

Futures contracts are usually marked to market.

Question 51

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one-year loan is 7 percent and a two-year loan is 8 percent, it should quote 9 percent.

Question 52

Four investors enter into long sugar contracts. Three are speculators and one is hedging. Which of the following is hedging?

A)Wheat farmer
B)Cereal company
C)Mutual fund
D)None of these answers are correct.

Question 53

Are companies that purchase or sell derivative contracts necessarily speculating?

Question 54

The convenience yield on a commodity futures contract is the implicit extra value created by holding the actual commodity rather than a financial claim on it.

Question 55

For commodity futures, (Futures price)× (1 + r_f)^t = spot price − net convenience yield.

Question 56

Derivative instruments are financial contracts whose value depends on the value of another asset.

Question 57

In bearing risk, what disadvantages do insurance companies face?

Question 58

Most of the world's largest companies use derivatives to manage risk.

Question 59

What investment would be a hedge for a corn farmer?

A)Long corn put option
B)Long corn call option
C)Long corn futures
D)None of these answers are correct.

Question 60

A company that wishes to lock in an interest rate on future borrowing can either enter into a forward rate agreement (FRA)or it can borrow long-term funds and lend short-term.

Question 61

Explain how a firm wishing to invest in floating rate investments can use a swap to manage its interest rate exposure?

Question 62

Briefly describe a swap contract.

Question 63

Why are derivatives necessary for a thriving economy?

Question 64

What is the difference between hedging, speculation, and arbitrage?

Question 65

Briefly explain the mechanics of homemade forward rate agreements.

Question 66

Briefly explain how a firm can hedge its risks using options.

Question 67

Briefly explain the term marked to market.