Deck 11: Derivatives Markets

Question 1

Basis risk is the risk that the price of futures contracts will not vary in exactly the same way as the price of the item being hedged.

Answer 1

True

Question 2

A hedger with a long spot position should buy futures to reduce their risk.

Answer 2

False

Question 3

A pension fund manager can protect his/her recent price gains by buying stock index futures contracts.

Answer 3

False

Question 4

Writing calls can generate potentially unlimited losses.

Question 5

The Chicago Board Options Exchange is the primary regulator of options contracts.

Question 6

The price sensitivity rule assists the hedger by estimating the number of futures contracts to trade.

Question 7

A hedger who is contracted to buy a commodity in the future may wish to reduce their price risk by buying futures contracts on the commodity.

Question 8

Futures markets involve more standardized contracts compared to forward markets.

Question 9

Futures contracts eliminate risk to all participants.

Question 10

A swap entails buying and selling a futures contract at the same time.

Question 11

Margin risk involves the chance that initial margin requirements will be increased once an investor buys the futures contract.

Question 12

The long financial futures hedger net loses when futures contracts are marked to market after an increase in the price of the underlying asset.

Question 13

A savings and loan with interest rate-sensitive liabilities and interest rate insensitive assets (i.e., a negative GAP) might swap future fixed rate interest payments to receive variable rate interest payments to reduce its risk.

Question 14

The open interest is the number of outstanding contracts that have not been offset.

Question 15

Options premiums vary directly with the maturity of the option.

Question 16

Most forward market contracts are settled before delivery.

Question 17

Margin requirements relate to the amount of cash down payment or equity one must havedeposited before participating in a futures trade.

Question 18

Portfolio insurance with stock index futures is used to eliminate unsystematic risk from stock portfolios.

Question 19

Cross-hedgers involve more basis risk than direct hedges.

Question 20

A depository institution can reduce the variability of its cost of funds by selling Eurodollar futures.

Question 21

A bank has made fixed rate loans funded with shorter term certificates of deposit. To reduce its interest rate risk the bank could sell short term interest rate futures.

Question 22

What determines whether a buyer or a seller of a derivative security is a hedger or a speculator?

Question 23

What role does the SEC have in regulating options markets? How does it differ from the role of the CFTC?

Question 24

At least one of two counterparties in a forward contract must be a speculator.

Question 25

A non-standardized agreement that is negotiated between a buyer and seller to exchange an asset for cash at some future date, with the price set today is called a future agreement.

Question 26

A bank has longer duration assets than liabilities and is considering using an interest rate swap to reduce its interest rate risk. Describe how a change in interest rates would impact the bank's equity. Should the bank pay a variable rate of interest and receive a fixed interest rate in the swap or vice versa? Explain why.

Question 27

A manager of a large stock portfolio has earned a respectable return by October, and would like to protect that return for the rest of the year using options. Describe the least risky way she could guarantee a certain portfolio return with trades in derivative securities.

Question 28

Speculators are gamblers that provide no social value to the economy.

Question 29

If a stock's price is $56 per share a call option with a $60 exercise price will cost less than an equivalent maturity put option with the same exercise price.

Question 30

A bank has made mortgages funded with 1 year certificates of deposit. To reduce its interest rate risk the bank could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest.

Question 31

A call option writer will profit if the underlying stock's volatility decreases in value, all else equal.

Question 32

If you forecast that interest rates are likely to decrease over the next several years, you might sell a T-bond futures contract or buy an interest rate cap to take advantage of your expectations.

Question 33

In general, writing calls is riskier than buying puts.

Question 34

Explain how forward and futures markets differ.

Question 35

If the option exercise price is greater than the current stock price, a call option is out-of-the-money but the put option is in-the-money.

Question 36

The writer of a call option on stock benefits if the underlying stock price decrease or if the volatility of the stock's price decreases.

Question 37

Explain how a bank that has made fixed rate mortgages funded by deposits could use futures or options to hedge against the possibility that interest rates will rise.

Question 38

Suppose a stock is priced at $100 currently. You are bullish on the stock and are considering buying May calls with an exercise price of $95 and $105 respectively. The call with an exercise price $95 is priced at $8.50 and the 105 call is quoted at $2.75.What should you consider in deciding which to purchase if you do not plan on exercising prior to maturity? What are the breakeven stock prices for the two calls?