Deck 22: Futures and Forwards

Question 1

Futures contracts are the primary security that insurance companies and banks use to hedge interest rate risk prior to originating mortgages.

Answer 1

False

Question 2

An off-balance-sheet forward position is used to hedge the FI's on-balance-sheet risk exposure.

Answer 2

True

Question 3

Delivery of the underlying asset almost always occurs in the futures market.

Answer 3

False

Question 4

Microhedging uses futures or forward contracts to hedge the entire balance sheet duration gap.

Question 5

Immunizing the balance sheet against interest rate risk means that gains (losses) from an off-balance-sheet hedge will exactly offset losses (gains) from the balance sheet position.

Question 6

Forward contracts are individually negotiated and, therefore, can be unique.

Question 7

Forward contracts are marked-to-market on a daily basis.

Question 8

Federal regulations in Canada allow derivatives to be used only by the 25 largest banks.

Question 9

A forward contract has only one payment cash flow that occurs at the time of delivery.

Question 10

A spot contract specifies deferred delivery and payment.

Question 11

More FIs fail due to credit risk exposure than exposure to either interest rate risk or foreign exchange risk.

Question 12

Commercial banks, investment banks, and broker-dealers are the major forward market participants.

Question 13

An FI with a negative duration gap is exposed to interest rate declines and could hedge its interest rate risk by buying forward contracts.

Question 14

In a forward contract agreement, the quantity of product to be traded, the time of the actual trade and the price are determined at the time of the agreement.

Question 15

A forward contract specifies immediate delivery for immediate payment.

Question 16

A perfect hedge, or perfect immunization, seldom occurs.

Question 17

A futures contract has only one payment cash flow that occurs at the time of delivery.

Question 18

An FI with a positive duration gap is exposed to interest rate declines and could hedge its interest rate risk by buying forward contracts.

Question 19

Derivative contracts allow an FI to manage interest rate and foreign exchange risk.

Question 20

It is not possible to separate credit risk exposure from the lending process itself.

Question 21

An adjustment for basis risk with a value of "br" less than one means that the percent change in the spot rates is greater than the change in rate in the deliverable bond in the futures market.

Question 22

Hedging foreign exchange risk in the futures market may involve uncertainty about all of the transactions necessary to achieve the hedge to fulfillment.

Question 23

Hedging a specific on-balance-sheet cash position usually will only require more T-bill futures contracts than hedging the same cash position with T-bond futures contracts because the T-bond contract size is only 10 percent as large as large as the T-bill contract.

Question 24

Hedging selectively only a portion of the balance sheet is an attempt to increase the return of the FI by accepting some level of interest rate risk.

Question 25

Routine hedging will allow the FI to achieve greater return from the assets and liabilities on the balance sheet.

Question 26

Basis risk occurs when the underlying security in the futures contract is not the same asset as the cash asset on the balance sheet.

Question 27

In a credit forward agreement hedge, the loss on the balance sheet cash position is offset completely by the gain on the off-balance-sheet credit forward agreement if the characteristics of the benchmark bond and the bank's loan to the borrower are the same.

Question 28

Selective hedging that results in an over-hedged position may be regarded as speculative by regulators.

Question 29

A conversion factor often is used to determine the invoice price on a futures contract when a bond other than the benchmark bond is delivered to the buyer.

Question 30

A credit forward agreement specifies a credit spread on a benchmark U.S. Treasury bond.

Question 31

Tailing-the-hedge normally requires an FI manager to utilize more futures contracts to hedge a cash position than are warranted by the initial analysis.

Question 32

The hedge ratio measures the impact that tailing-the-hedge will have on the number of contracts necessary to hedge the cash position.

Question 33

Selective hedging occurs by reducing the interest rate risk by selling sufficient futures contracts to offset the interest rate risk exposure of a portion of the cash positions on the balance sheet.

Question 34

The sensitivity of the price of a futures contract depends on the duration of the deliverable asset underlying the contract.

Question 35

Hedging effectiveness often is measured by the squared correlation between past changes in the spot asset prices and futures prices.

Question 36

Catastrophe futures are designed to hedge extreme losses of natural disasters for property & casualty insurance companies.

Question 37

The use of futures contracts by banks is subject to risk-based capital guidelines through the off-balance-sheet risk calculations for risk-based capital.

Question 38

Macrohedging uses a derivative contract, such as a futures or forward contract, to hedge a particular asset or liability risk.

Question 39

The payoff on a catastrophe futures contract is adjusted for the actual loss ratio of the insurer.

Question 40

All bonds that are deliverable under a Treasury bond futures contract have a maturity of 20 years and an interest rate of 8 percent.

Question 41

A futures contract

A)is tailor-made to fit the needs of the buyer and the seller.
B)has more credit risk than a forward contract.
C)is marked to market more frequently than a forward contract.
D)has a shorter time to delivery than a forward contract.
E)has more price risk than a forward contract.

Question 42

Futures contracts are standard in terms of all of the following EXCEPT

A)contract size.
B)delivery month.
C)specific asset to be delivered.
D)trading hours.
E)daily price limits.

Question 43

An agreement between a buyer and a seller at time 0 to exchange a pre-specified asset for cash at a specified later date is the characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 44

Financial futures can be used by FIs to manage

A)credit risk.
B)interest rate risk.
C)liquidity risk.
D)foreign exchange risk.
E)credit risk, interest rate risk, and foreign exchange risk.

Question 45

The primary benefit of a futures exchange is

A)always knowing its exact location.
B)indemnifying counterparties against credit or default risk.
C)guarantee of trading volume.
D)intervention on the trader's behalf with government regulators.
E)availability of free legal services.

Question 46

Which of the following identifies the largest group of derivative contracts as of June 2012?

A)Futures.
B)Forwards.
C)Options.
D)Swaps.
E)Credit derivatives.

Question 47

An FI has reduced its interest rate risk exposure to the lowest possible level by selling sufficient futures to offset the risk exposure of its whole balance sheet or cash positions in each asset and liability. The FI is involved in

A)microhedging.
B)selective hedging.
C)routine hedging.
D)overhedging.
E)speculation.

Question 48

What is overhedging?

A)Selectively hedging a proportion of an FI's balance sheet position.
B)Choosing to bear some interest rate risk as well as credit and FX risks.
C)Reducing the risk to the lowest level possible.
D)Using more hedge vehicles than is necessary to offset the risk in the cash asset.
E)Partially hedging the individual assets and liabilities.

Question 49

Which of the following measures the dollar value of futures contracts that should be sold per dollar of cash position exposure?

A)Hedge ratio.
B)Open position.
C)Implied volatility.
D)Payoff.
E)Risk ratio.

Question 50

An agreement between a buyer and a seller at time 0 where the seller of an asset agrees to deliver an asset immediately and the buyer agrees to pay for the asset immediately is the characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 51

Why does basis risk occur?

A)Changes in the spot asset's price are not perfectly correlated with changes in the price of the asset delivered under a forward or futures contract.
B)The daily marking-to-market process enables an FI manager to close out a futures position by taking an exactly offsetting position.
C)Spot and futures contracts are traded in different markets with different demand and supply functions.
D)None of these.
E)Changes in the spot asset's price are not perfectly correlated with changes in the price of the asset delivered under a forward or futures contract, and spot and futures contracts are traded in different markets with different demand and supply functions.

Question 52

A naive hedge occurs when

A)an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap.
B)a cash asset is hedged on a direct dollar-for-dollar basis with a forward or futures contract.
C)an FI reduces its interest rate or other risk exposure to the lowest possible level by selling sufficient futures to offset the interest rate risk exposure of its whole balance sheet.
D)an FI purchases an insurance cover to the extent of 80% of losses arising from adverse movement in asset prices.
E)All of these.

Question 53

An FI issued $1 million of 1-year maturity floating rate commercial paper. The commercial paper is repriced every three months at the 91-day Treasury bill rate plus 2 percent. What is the FI's interest rate risk exposure and how can it use financial futures and options to hedge that risk exposure?

A)The FI can hedge its exposure to interest rate increases by selling financial futures.
B)The FI can hedge its exposure to interest rate decreases by selling financial futures.
C)The FI can hedge its exposure to interest rate increases by buying financial futures.
D)The FI can hedge its exposure to interest rate increases by buying call options.
E)The FI cannot hedge its exposure to interest rate increases or decreases using financial futures

Question 54

A forward contract

A)has more credit risk than a futures contract.
B)is more standardized than a futures contract.
C)is marked to market more frequently than a futures contract.
D)has a shorter time to delivery than a futures contract.
E)is less risky than a futures contract.

Question 55

What is a difference between a forward contract and a future contract?

A)The settlement price of a forward contract is fixed over the life of the contract but in a futures contract is marked to market daily.
B)Forward contracts are normally arranged through an organized exchange, while most futures contracts are OTC contracts.
C)Both are essentially the same, except for trading volumes which are higher for futures contracts.
D)Both are essentially the same, except for the fact that the terms of a forward contract is set by an exchange, subject to the approval of the Commodity Futures Trading Commission (CFTC).
E)Delivery of the underlying asset almost always occurs on a futures contract but almost never occurs on a forward contract.

Question 56

An agreement between a buyer and a seller at time 0 to exchange a standardized, pre-specified asset for cash at a specified later date is characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 57

Routine hedging

A)is a hedging strategy that occurs on a set, predetermined basis by the FI.
B)always results in excess returns.
C)is a strategy to follow when interest rates are abnormally low.
D)is a strategy used when interest rates are extremely unpredictable.
E)is a strategy to follow when interest rates are abnormally high.

Question 58

Which of the following is an example of microhedging asset-side portfolio risk?

A)When an FI, attempting to lock in cost of funds to protect itself against a rise in short-term interest rates, takes a short position in futures contracts on CDs.
B)FI manager trying to pick a futures contract whose underlying deliverable asset is not matched to the asset position being hedged.
C)When an FI hedges a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.
D)When an FI manager wants to insulate the value of the institution's bond portfolio fully against a rise in interest rates.
E)When an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap.

Question 59

The number of futures contracts that an FI should buy or sell in a macrohedge depends on the

A)size of its interest rate risk exposure.
B)direction of its interest rate risk exposure.
C)return risk trade-off from fully hedging that risk.
D)return risk trade-off from selectively hedging that risk.
E)All of these.

Question 60

Which of the following indicates the need to place a hedge?

A)The price movement in the underlying cash asset cannot be forecasted perfectly.
B)The prices of the assets or liabilities are imperfectly correlated over time with the prices on the futures.
C)Basis risk prevents the minimum risk of the portfolio from reaching zero.
D)Treasury has been issuing more shorter-dated bonds to finance U.S. budget deficits.
E)Spot bonds and futures on bonds are traded in different markets.

Question 61

The current price of June $100,000 T-Bonds trading on the Chicago Board of Trade is 109-24. What is the price to be paid if the contract is delivered in June?

A)$107,240.
B)$109,240.
C)$109,750.
D)$110,250.
E)$115,760.

Question 62

Who are the common buyers of credit forwards?

A)Insurance companies.
B)Banks.
C)Federal Reserve.
D)Stock brokers.
E)Credit unions.

Question 63

What does R² = 0 indicate?

A)Changes in the spot rate and changes in the futures price are perfectly correlated.
B)All observations between changes in spot rate and changes in futures price lie on a straight line.
C)The spot and future exchange rates are expected to move imperfectly together.
D)The FI must sell a greater number of futures to hedge the cash position.
E)There is no statistical association between changes in spot rates and changes in futures price.

Question 64

The covariance of the change in spot exchange rates and the change in futures exchange rates is 0.6060, and the variance of the change in futures exchange rates is 0.5050. What is the estimated hedge ratio for this currency?

A)0.306.
B)0.694.
C)1.440.
D)1.200.
E)0.833.

Question 65

How is a hedge ratio commonly determined?

A)By discounting the optimal number of futures to sell per $1 of cash position using the yield involved.
B)By using the ratio of the most recent spot and futures price changes.
C)By running an ordinary least squares regression of changes in spot prices on changes in futures prices.
D)By using the conversion factor.
E)By squaring the correlation between past changes in spot asset prices and futures prices.

Question 66

What does a low value of R² indicate?

A)It means the degree of confidence increases in the use of futures contracts, with a given hedge ratio estimate, to hedge cash asset-risk position.
B)It means that we have little confidence that the slope coefficient from the regression is actually the true hedge ratio.
C)It indicates that there is no statistical association at all between spot rates and future prices.
D)It indicates that the regression line does not fit the scatter of observations.
E)It indicates a low value of hedging ineffectiveness.

Question 67

A credit forward is a forward agreement that

A)hedges against a decrease in default risk on a loan after the loan rate is determined and the loan issued.
B)hedges against an increase in default risk on a loan before the loan rate is determined and the loan issued.
C)hedges against an increase in default risk on a loan after the loan rate is determined and the loan issued.
D)hedges against a decrease in default risk on a loan before the loan rate is determined and the loan issued.
E)hedges against an increase in default risk on a loan after the loan rate is determined and before the loan is issued.

Question 68

The covariance of the change in spot exchange rates and the change in futures exchange rates is 0.6606, and the variance of the change in futures exchange rates is 0.6060. The variance of the change in spot exchange rates is 0.9090. What is the degree of hedging effectiveness?

A)0.61.
B)0.90.
C)0.87.
D)0.82.
E)0.79.

Question 69

Historical analysis of recent changes in exchange rates in both the spot and futures markets for a given currency reveals that spot rates are thirty percent more sensitive than futures prices. Given this information, the hedge ratio for this currency is

A)0.70.
B)0.77.
C)1.30.
D)1.43.
E)1.86.

Question 70

What is the purpose of a credit forward agreement?

A)To allow property-casualty insurers to hedge the extreme losses that occur after major catastrophes.
B)To adjust prices on outstanding futures each day to reflect current futures market conditions.
C)To facilitate the future exchange of an asset for cash at a price that is determined daily.
D)To hedge a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.
E)To hedge against an increase in the default risk of a loan.

Question 71

If a 12-year, 6.5 percent semi-annual $100,000 T-bond, currently yielding 4.10 percent, is used to deliver against a 6-year, 5 percent T-bond at 110-17/32, what is the conversion factor? What would the buyer have to pay the seller?

A)1.1027; $110,531.
B)1.2257; $135,478.
C)1.8370; $253,830.
D)1.3622; $163,339.
E)1.7263; $141,788.

Question 72

In a credit forward contract transaction

A)the credit forward buyer is the lender who is trying to hedge the loan.
B)the credit forward seller is the lender who is trying to hedge the loan.
C)the credit forward buyer will pay the credit forward seller if the credit spread at the maturity of the forward contract is less than at the initiation of the contract.
D)the credit forward seller will pay the credit forward buyer if the credit spread at the maturity of the forward contract is greater than at the initiation of the contract.
E)the characteristics of the benchmark bond must be the same as those of the bank's loan to the borrower.

Question 73

If a 16-year 12 percent semi-annual $100,000 T-bond, currently yielding 10 percent, is used to deliver against a 20-year, 8 percent T-bond at 114-16/32, what is the conversion factor? What would the buyer have to pay the seller?

A)1.158; $132,591.
B)1.156; $115,600.
C)1.150; $131,284.
D)1.102; $124,200.
E)1.000; $114,160.

Question 74

The notational value of the world-wide credit derivative securities markets stood at _________ trillion as of June 2012, which compares to _________ trillion as of July 2008.

A)$24.9; $54.6
B)$13.2; $31.2
C)$31.2; $16.8
D)$7.8; $14.7
E)$16.0; $27.4

Question 75

What is the reason for decrease in the number of futures contract needed to hedge a cash position in case of tailing the hedge?

A)Lower average transaction costs resulting from higher number of transactions.
B)Interest income generated from reinvesting the cash flows generated by the futures contracts.
C)Lack of perfect correlation between spot and futures prices.
D)The effect of conversion factor.
E)Hedging only a proportion of balance sheet position.

Question 76

XYZ Bank lends $20,000,000 to ABC Corporation which has a credit rating of BB. The spread of a BB rated benchmark bond is 2.5 percent over the U.S. Treasury bond of similar maturity. XYZ Bank sells a $20,000,000 one-year credit forward contract to IWILL Insurance Company. At maturity, the spread of the benchmark bond against the Treasury bond is 2.1 percent, and the benchmark bond has a modified duration of 4 years. What is the amount of payment paid by whom to whom at the maturity of the credit forward contract?

A)The seller pays the buyer $320,000.
B)The buyer pays the seller $320,000.
C)The seller pays the buyer $80,000.
D)The buyer pays the seller $80,000.
E)The borrower receives $240,000.

Question 77

Which of the following is NOT true regarding hedge ratio?

A)When there is no basis risk hedge ratio is equal to one.
B)When h = 1, both spot and futures are expected to change together by the same absolute amount.
C)When h = 1, FX risk of the cash position should be hedged dollar for dollar by buying FX futures.
D)When basis risk is present, the spot and future exchange rates are expected to move imperfectly together.
E)The FI must sell a greater number of futures when there is basis risk than it has to when basis risk is absent.

Question 78

Catastrophe futures contracts

A)are designed to protect life insurance companies from the effects of natural disasters in which large numbers of lives are lost.
B)are designed to protect property-casualty insurers against the extreme losses that can occur in hurricanes.
C)are designed to hedge insurance companies from liability law suits.
D)provide a payoff when the actual loss ratio is less than the expected loss ratio.
E)provide a payoff to the seller of the contract that is equal to the loss ratio times the nominal value of the contract.

Question 79

Selling a credit forward agreement generates a payoff similar to

A)selling a call option.
B)buying a call option.
C)selling a put option.
D)buying a put option.
E)buying forward contracts.

Question 80

When will the estimated hedge ratio be greater than one?

A)When spot rate changes are greater than futures rate changes.
B)When spot rate changes are less sensitive than futures price changes over time.
C)When spot rate changes are equally sensitive as futures price changes over time.
D)When basis risk is absent.
E)When the spot and future exchange rates are expected to move perfectly together.