Deck 29: The Applications of Futures and Options Contracts

Question 1

Suppose that a pension fund manager knows that bonds must be liquidated in 40 days to make a $5 million payment to the beneficiaries of the pension fund. If interest rates rise in 40 days, more bonds will have to be liquidated to realize $5 million. The hedger will buy put options thus following ________.

A) an unprotected call buying strategy.
B) a protective put buying strategy.
C) a protective put selling strategy.
D) an unprotected put buying strategy.

Answer 1

B

Question 2

An institutional investor can use interest rate options or options on interest rate futures to speculate on ________ based on expectations of interest rate changes.

A) flexible-income security price movements
B) fixed-income security price movements
C) common stock price movements
D) None of these

Answer 2

B

Question 3

A strategy that seeks to insure the value of a portfolio through the use of a synthetic put option strategy is called dynamic hedging. Given that put options on stock indexes are available to portfolio managers, why should they bother with dynamic hedging? There are four reasons and one of these is ________.

A) The size of the market for options on stock indexes is as large as that for stock index futures.
B) Exchanges do not impose limits on the number of contracts in which an investor can have a position.
C) Existing exchange-traded index options contracts are of longer maturity than the period over which some investors seek protection.
D) The cost of a put option may be higher than the transactions costs associated with dynamic hedging.

Answer 3

D

Question 4

Market participants can employ interest rate futures in various ways. These include ________.

A) speculating on the movement of risk-free rates.
B) controlling the interest rate risk of a bond.
C) hedging against known interest rate movements.
D) enhancing returns when futures are mispriced.

Question 5

A corporation planning to sell long-term bonds two months from now can protect itself against a rise in interest rates by selling or taking ________ in interest rate futures now.

A) a long position
B) a passive or neutral position
C) a short position
D) an aggressive or active position

Question 6

An investor who wants to speculate that interest rates will rise (fall) can sell (buy) ________.

A) interest rate futures.
B) stock index futures.
C) bond index futures.
D) interest rate movements.

Question 7

Prior to the development of ________, an investor who wanted to speculate on the future course of aggregate stock prices had to buy or short individual stocks.

A) mutual stock funds
B) mutual bond funds
C) stock index futures
D) bond index futures

Question 8

An institutional investor can create a put option synthetically by using either ________.

A) stocks or a riskless asset.
B) stock index futures or stocks.
C) stock index futures or a riskless asset.
D) stock index futures or stocks and a riskless asset.

Question 9

Which of the below statements is TRUE?

A) Stock options cannot be used to take advantage of the anticipated price movement of individual stocks.
B) An investor can protect against a decline in the price of a stock in her portfolio by buying a call option on that stock.
C) By taking an appropriate position in a suitable stock index option, an institutional investor can create a protective put for part of the diversified portfolio.
D) A protective put buying strategy allows an investor to protect against a decline in the price of a stock in her portfolio by buying a put option on that stock.

Question 10

If the futures price is ________ the theoretical futures price (that is, the futures contracts are cheap), the index fund manager can ________ the indexed portfolio's return by buying the futures and buying the Treasury bills.

A) less than; enhance
B) greater than; enhance
C) greater than; maintain
D) less than; worsen

Question 11

Suppose that a money manager knows that bonds are maturing in the near future and expects interest rates to fall. ________ can be purchased in this situation.

A) Call options
B) Put options
C) Dividend paying stocks
D) Growth firms

Question 12

________ monitor the cash and futures market to see when the differences between the theoretical futures price and actual futures price are sufficiently large to generate an ________.

A) Money managers and advisors; advising profit
B) Money managers and arbitrageurs; arbitrage profit
C) Portfolio managers and arbitrageurs; risk-adjusted profit
D) Money managers and advisors; risk-adjusted profit

Question 13

There are three advantages of using interest rate futures instead of the cash market (trading long-term Treasuries themselves). One of these advantages is that ________.

A) the transactions costs of using futures are higher than those in the corresponding cash market.
B) margin requirements are lower for futures than for Treasury securities; using futures thus permits less leverage.
C) it is easier to take a short position in the futures market than to sell short in the Treasuries market.
D) All of these

Question 14

A corporation that plans to sell commercial paper one month from now can use ________ to lock in a commercial paper rate.

A) Treasury bill purchases or commercial paper futures.
B) commercial paper futures or Eurodollar CD futures.
C) interest rate futures or Eurodollar CD purchases.
D) Treasury bill futures or Eurodollar CD futures.

Question 15

If interest rate futures are ________, institutional investors can enhance returns in the same way that they do in equities.

A) mispriced
B) correctly priced
C) in short supply
D) None of these

Question 16

Because the put option buyer gains when the price of the underlying stock index declines, purchasing a ________ will offset any adverse movements in the portfolio's value due to a ________ in the stock market.

A) put option; decline
B) call option; decline
C) put option; rise
D) All of these

Question 17

Institutional investors can use stock index futures for seven distinct investment strategies. These include ________.

A) speculating on the movement of the bond market.
B) hedging against adverse stock price movements.
C) controlling indexed portfolios.
D) index allocation.

Question 18

In a ________, the objective is to alter a current or anticipated stock portfolio position so that its ________ is zero.

A) hedging strategy; beta
B) speculative strategy; standard deviation
C) diversified strategy; beta
D) nondiversified strategy; standard deviation

Question 19

While investment managers can alter the interest rate sensitivity of their portfolios with cash market instruments, a quick and inexpensive means for doing so (on either a temporary or permanent basis) is to use ________.

A) bond indentures.
B) stock index contracts.
C) interest rate treaties.
D) futures contracts.

Question 20

The decision on how to divide funds across the major asset classes (for example, equities, bonds, foreign securities, real estate) is referred to as the ________.

A) index arbitrage decision.
B) portfolio insurance decision.
C) controlling the risk decision.
D) asset allocation decision.

Question 21

A corporation plans to sell commercial paper one month from now. Buying put options on Treasury bill futures or Eurodollar CD futures lets the corporation ________.

A) set a floor on its commercial paper interest cost.
B) set a ceiling on its commercial paper interest profits.
C) set a ceiling on its commercial paper interest cost.
D) set a floor on its commercial paper purchases.

Question 22

Interest rate options or options on interest rate futures can be used by investors and issuers to speculate on adverse interest rate movements but still benefit from a favorable interest rate movement.

Question 23

A money manager can use both stock index futures and interest rate futures to more efficiently allocate funds between the stock market and the bond market.

Question 24

Market participants can obtain downside protection using options at a cost equal to the option price, but preserve upside potential (reduced by the option price).

Question 25

The difference between the cash price and the futures price is called the ________.

A) future difference.
B) cash-future difference.
C) basis.
D) basis point.

Question 26

A protective put buying strategy can be used to reduce the risk exposure of a stock portfolio to a decline in stock prices, guaranteeing a maximum price equal to the strike price plus the cost of buying the put option.

Question 27

Investors can use stock index futures to speculate on stock prices, control a portfolio's price risk exposure, hedge against adverse stock price movements, construct indexed portfolios, engage in index arbitrage, and create a synthetic put option.

Question 28

Because futures are highly leveraged and transactions costs are less than in the cash market, market participants can alter their risk exposure to a market (stock or bond) less efficiently in the futures market.

Question 29

By taking an appropriate position in a suitable stock index option, an institutional investor can create a protective call for a diversified portfolio.

Question 30

In regards to hedging, which of the below statements is FALSE?

A) Hedging is the employment of a futures transaction as a temporary substitute for a transaction in the cash market.
B) As long as cash and futures prices move together, any loss realized on one position (whether cash or futures) will be offset by a profit on the other position.
C) The hedge position locks in a value for the cash position.
D) When the profit and loss are equal, the hedge is called an equal hedge.

Question 31

Buying a futures contract decreases a market participant's exposure to a market; selling a futures contract decreases a market participant's exposure to a market.

Question 32

Market participants can use interest rate futures to control interest rate movements, speculate on a portfolio's risk exposure to interest rate changes, hedge against adverse interest rate movements, and enhance returns when futures are mispriced.

Question 33

The major function of futures markets is to transfer price risk from ________.

A) aggressive investors to speculators.
B) hedgers to conservative investors.
C) speculators to hedgers.
D) hedgers to speculators.

Question 34

The purchase of a call option can be used to guarantee that the maximum price that will be paid in the future is the strike price plus the option price.

Question 35

The effectiveness of a cross hedge will be determined by ________.

A) the relationship between the cash price of the underlying instrument and the price of a complement to the underlying instrument.
B) the relationship between the cash price of the underlying instrument and its futures price at the time when a hedge is placed and the time when it is lifted.
C) the relationship between the market value of the portfolio and the cash price of the instrument after hedge is placed.
D) the relationship between the market value of the portfolio and the cash price of the instrument before the hedge is lifted.

Question 36

When a futures contract is used to hedge a position where either the portfolio or the individual financial instrument is not identical to the instrument underlying the futures, it is called ________.

A) perfect hedging.
B) a cross instrument.
C) cross hedging.
D) an hedged instrument.

Question 37

A corporation plans to issue long-term bonds two months from now. To protect itself against a rise in interest rates, the corporation can buy put options. If interest rates rise, the interest cost of the bonds issued two months from now will be ________, but the put option will have ________ in value.

A) higher; decreased
B) lower; increased
C) higher; increased
D) lower; not changed

Question 38

A long hedge is used to protect against a decline in the cash price of a financial instrument or portfolio.

Question 39

A thrift or commercial bank wants to make sure that the cost of its funds will not exceed a certain level. This can be done by ________.

A) buying Eurodollar CDs.
B) selling put options on Eurodollar CD futures.
C) buying call options on Eurodollar CD futures.
D) buying put options on Eurodollar CD futures.

Question 40

A short hedge is undertaken to protect against an increase in the price of a financial instrument or portfolio to be purchased in the cash market at some future time.

Question 41

Explain how a "protective put buying strategy" works.

Question 42

Institutional investors can use stock index futures for seven distinct investment strategies. Name four of these strategies.

Question 43

An institution that wishes to alter its exposure to the market can do so by revising the portfolio's beta. Describe how this can be done.

Question 44

When a futures contract is used to hedge a position where either the portfolio or the individual financial instrument is not identical to the instrument underlying the futures, it is called cross hedging. Cross hedging is common in asset/liability and portfolio management and in hedging a corporate bond issuance. Answer the below questions.
(a) Why is cross hedging common?
(b) What does it introduce?
(c) What two factors determine the effectiveness of a cross hedge?

Question 45

Give two examples of how interest rate futures can be used to hedge against adverse interest rate movements by locking in either a price or an interest rate.

Question 46

A long hedge is also known as a buy hedge.

Question 47

Market participants can use interest rate futures in various ways. Name three of these ways.