Deck 4: Introduction to Risk Management

Question 1

Corn call options with a $1.70 strike price are trading for a $0.15 premium. Farmer Jayne decides to hedge her 20,000 bushels of corn by selling short call options. Six-month interest rates are 4.0% and she plans to close her position and sell her corn in 6 months. What is her profit or loss if spot prices are $1.60 per bushel when she closes her position?

A) $1,000 loss
B) $2,000 gain
C) $2,120 loss
D) $2,120 gain

Answer 1

D

Question 2

Besides speculation, what is another reason risk managers may employ stack and roll hedging strategies?

A) Near term contracts have more volume
B) Commodity prices are more attractive
C) Arbitrage usually exists
D) Mispricing occurs frequently at long term maturities

Answer 2

A

Question 3

A $1.75 strike call option has a $0.14 premium. The $1.75 strike put option premium is $0.12. What is the net cost for Farmer Jayne to create a synthetic short forward contract? (Assume 4.0% interest.)

A) $0.0208
B) -$0.0208
C) $0.000
D) -$0.0424

Answer 3

A

Question 4

An airline is deciding to hedge with crude oil futures, gasoline futures, heating oil futures or natural gas futures. Given their associated R-squared relationships between each commodity and jet fluke prices, which futures contract offers the best hedge?

A) Crude oil, R² = .25
B) Gasoline, R² = .18
C) Heating oil, R² = .46
D) Natural gas, R² = .36

Question 5

A bank makes a long term loan and funds the loan by issuing certificates of deposit today, at three months, six months and nine months. To hedge the interest rate risk of issuing the CDs, the bank enters into futures contracts with maturities of 3, 6 and 9 months. Which type of hedge is described by this strategy?

A) Pure hedge
B) Stack hedge
C) Straight hedge
D) Strip hedge

Question 6

Two 6-month corn put options are available. The strike prices are $1.80 and $1.75 with premiums of $0.14 and $0.12, respectively. Total costs are $1.65 per bushel and 6-month interest rates are 4.0%. Farmer Jayne wishes to hedge 20,000 bushels for 6 months. What is the highest profit or minimum loss between the two options if the spot price in 6 months is $1.70 per bushel?

A) $88 loss
B) $88 gain
C) $496 loss
D) $496 gain

Question 7

To plant and harvest 20,000 bushels of corn, Farmer Jayne incurs fixed and variable costs totaling $33,000. The current spot price of corn is $1.80 per bushel. What is the profit or loss if the spot price is $1.90 per bushel when she harvests and sells her corn?

A) $3,000 gain
B) $3,000 loss
C) $5,000 gain
D) $5,000 loss

Question 8

A farmer sells 4 million bushels of corn at a spot price of $2.10 per bushel. The total cost of production was $9.2 million. The farmer has an effective tax rate of 25%. If the farmer entered into a futures contract at a price of $2.40 per bushel on 4 million bushels, what is the farmerʹs net loss or gain?

A) $100,000 loss
B) $800,000 loss
C) $300,000 gain
D) $400,000 gain

Question 9

Corn call options with a $1.75 strike price are trading for a $0.14 premium. Farmer Jayne decides to hedge her 20,000 bushels of corn by selling short call options. Six-month interest rates are 4.0% and she plans to close her position in 6 months. What is the total premium she will earn on her short position?

A) $2,800
B) $2,912
C) $800
D) $1,600

Question 10

Farmer Jayne bought a $1.70 strike put option for $0.11 and sold a $1.75 strike call option for a premium of $0.14. Her total costs are $1.65 per bushel and interest rates are 4.0% over this period. What is the floor in her strategy assuming a 20,000-bushel crop?

A) $624
B) $1,624
C) $2,624
D) $3,624

Question 11

Midwest Airlines is short 2 million gallons of jet fuel. Since no jet fuel contract exists, they decide to hedge with crude oil futures. The price of jet fuel is currently $2.70 per gallon and the price of crude oil is $99 per barrel. Assuming they hold the correct number of crude oil futures contracts, what crude oil price will be needed to perfectly hedge an increase in jet fuel prices to $2.84 per gallon?

A) $ 2.84
B) $ 94.12
C) $ 99.00
D) $ 104.13

Question 12

When selecting among various put options with different strike prices, in order to hedge a long asset position, which of the following statements is true?

A) Higher strike puts cost more and provide higher floors
B) Higher strike puts cost less and provide higher floors
C) Lower strike puts cost more and provide higher floors
D) Lower strike puts cost less and provide higher floors

Question 13

Midwest Airlines is short 2 million gallons of jet fuel. Since no jet fuel contract exists, they decide to hedge with crude oil futures. One 42 barrel of crude oil is needed to produce 20 gallons of jet fuel. If one contract is for 1,000 barrels, how many crude oil contracts will they need to properly hedge their exposure?

A) 2,000 contracts
B) 4,200 contracts
C) 20 million contracts
D) 42 million contracts

Question 14

A 6-month forward contract for corn exists with a price of $1.70 per bushel. If Farmer Jayne decides to hedge her 20,000 bushels of corn with the forward contract, what is her profit or loss if spot prices are $1.65 or $1.80 when she sells her crop in 6 months? Her total costs are $33,000.

A) $1,000 gain or $1,000 loss
B) $0 gain or $3,000 gain
C) $0 loss or $3,000 loss
D) $1,000 gain or $1,000 gain

Question 15

A farmer expects to harvest 800,000 bushels of corn. To eliminate price risk, the farmer elects to short corn futures. What would cause the farmer to short only 720,000 bushels of corn?

A) Basis risk
B) Illiquid futures markets
C) Margin requirements
D) Quantity uncertain

Question 16

Which type of hedge has elements of speculation?

A) Pure hedge
B) Stack hedge
C) Straight hedge
D) Strip hedge

Question 17

Which of the following situations does NOT describe someone who should implement a hedge strategy?

A) Mary is very nervous about losing profits if selling prices drop
B) Melanieʹs creditors will not lend her money if her crops might lose money
C) Katherineʹs board of directors will not tolerate losses, even if it means profits are smaller
D) Dawn wants to reduce price fluctuations, but will need to conduct many transactions to achieve her goals

Question 18

KidCo. Cereal Company sells ʺSugar Cornsʺ for $2.50 per box. The company will need to buy 20,000 bushels of corn in 6 months to produce 40,000 boxes of cereal. Non-corn costs total $60,000. What is the companyʹs profit if they purchase call options at $0.12 per bushel with a strike price of $1.60? Assume the 6-month interest rate is 4.0% and the spot price in 6 months is $1.65 per bushel.

A) $6,504 profit
B) $8,005 loss
C) $12,064 profit
D) $11,293 loss

Question 19

Farmer Jayne decides to hedge 10,000 bushels of corn by purchasing put options with a strike price of $1.80. Six-month interest rates are 4.0% and the total premium on all puts is $1,200. If her total costs are $1.65 per bushel, what is her marginal change in profits if the spot price of corn drops from $1.80 to $1.75 by the time she sells her crop in 6 months?

A) $248 loss
B) $0
C) $252 gain
D) $1,500 loss

Question 20

KidCo. bought forward contracts on 20,000 bushels of corn at $1.65 per bushel. Corporate tax rates are 35.00%. Revenue is $100,000 and other costs are $60,000. Spot prices on corn are $1.75 per bushel. Calculate the after-tax net income.

A) $7,000 loss
B) $7,000 gain
C) $4,550 loss
D) $4,550 gain

Question 21

Why are managerial controls over option and forward trading departments vital to proper risk control?

Question 22

Why would a manufacturer elect to use a long call strategy instead of a forward contract to hedge the risk associated with variable costs?

Question 23

From a strictly conceptual perspective, why would any manufacturer consider hedging their variable costs? Answer as if you own the company.

Question 24

Why are synthetics created and/or calculated when the actual derivative is available?

Question 25

Explain the relationship between options costs and profits under a put option insurance strategy.