Deck 26: Managing Risk

Question 1

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

Answer 1

I,II,and III only

Question 2

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

Answer 2

basis risk

Question 3

Insurance companies,by issuing Cat bonds (catastrophe bonds),share their risks with:
I.the government;
II.other insurance companies;
III.bond investors

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

Answer 3

III only

Question 4

A type of risk peculiar to a forward contract is called:

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

Question 5

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 6

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 7

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 8

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 9

In addition to bearing risk,insurance companies also bear:
i.administrative costs; II)moral hazard costs; III)adverse selection costs

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

Question 10

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 clearingho

Question 11

Insurance companies face the following problem(s):

A)administrative costs.
B)adverse selection.
C)moral hazard.
D)all of these answers.

Question 12

The term "derivatives" refers to:
i.forwards; II)futures; III)swaps; IV)options

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

Question 13

Generally,hedging transactions are:

A)negative NPV transactions.
B)positive NPV transactions.
C)zero-NPV transactions.
D)none of these answers.

Question 14

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 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

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 17

The price for immediate delivery of a commodity is called the:

A)forward price.
B)exercise price.
C)spot price.
D)impact 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 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 20

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

Question 21

Suppose that the current level of the S&P 500 Index is 1100.The prospective dividend yield is 3%,and the current risk-free interest rate is 7%.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)1056
B)1144
C)1210
D)995

Question 22

The spot price of wheat is $2.90/bushel.The one-year futures price is $3.00/bushel.If the risk-free rate is 5%,calculate the net convenience yield.

A)-0.016
B)+0.016
C)+0.0345
D)+0.045

Question 23

A forward interest rate contract is called a(an):

A)interest rate options agreement.
B)forward rate agreement.
C)futures rate agreement.
D)none of these answers.

Question 24

First National Bank recently made a 5-year,$100 million fixed-rate loan at 10%.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% for 5 years,what is the notional principal of the swap?

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

Question 25

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

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

Question 26

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

Question 27

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

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

Question 28

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

A)6.5%
B)7.0%
C)7.5%
D)8.0%

Question 29

In a "total return swap" the underlying asset might be a:
I.common stock
II.loan
III.commodity
IV.market index

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

Question 30

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 31

Suppose that the current level of the Standard & Poor's Index is 500.The prospective dividend yield on S&P500 stocks is 2%,and the risk-free interest rate is 6%.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 32

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% per year,what is the net convenience yield?

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

Question 33

Third National Bank has made a 10-year,$25 million fixed-rate loan at 12%.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% for 10 years,what is the notional principal of the swap?

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

Question 34

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 35

Suppose that the current level of the Standard and Poor's Index is 950.The prospective dividend yield on S&P500 stocks is 3%,and the risk-free interest rate is 5%.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)1026

Question 36

Suppose that you bought eight Euro currency futures contracts .

A)$22,680,$22,180,$20,380,$19,280,$29,280
B)$22,680,$22,380,$20,180,$19,280,$29,280
C)$22,680,$22,180,$19,280,$22,380,$29,280
D)none of these answers

Question 37

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

A)10.0%
B)10.5%
C)11.0%
D)11.5%

Question 38

Hedging contracts on a futures exchange eliminates:

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

Question 39

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 40

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

A)Farmer
B)Cereal company
C)Mutual fund
D)None of these answers

Question 41

Briefly explain the term marked to market.

Question 42

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

Question 43

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

Question 44

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

Question 45

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% and a two-year loan is 8%,it should quote 7.5%,which is the average of the two rates.

Question 46

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

Question 47

In bearing risk,what disadvantages do insurance companies face?

Question 48

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

Question 49

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

Question 50

Are companies that purchase or sell derivative contracts necessarily speculating?

Question 51

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

Question 52

Options contracts are usually marked to market.

Question 53

For commodity futures: (Futures price)x (1 + r_f)^t = spot price - net convenience yield.

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

Briefly explain the term derivative.

Question 56

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

Question 57

Briefly explain the mechanics of homemade forward rate agreements.

Question 58

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% and a two-year loan is 8%,it should quote 9%.

Question 59

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

Question 60

For financial futures: (Spot price)/(1 + r_f - y)^t = futures price.

Question 61

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

Question 62

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

Question 63

Why are derivatives necessary for a thriving economy?

Question 64

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

Question 65

Briefly describe a swap contract.