Deck 23: Managing Risk Off the Balance Sheet With Derivative Securities

Question 1

The writer of an American-style bond call option has the right, but not the obligation, to buy the bond at a preset price until the option expires.

Answer 1

False

Question 2

A spot contract is an immediate delivery versus payment contract.

Answer 2

True

Question 3

The lack of perfect correlation between spot and futures prices implies that most hedges will have some basis risk.

Answer 3

True

Question 4

Futures contracts are not subject to capital requirements for banks, but many forward contracts are.

Question 5

Swaps are usually the best hedging tool to use to hedge long-term risks of 4 or 5 years or more.

Question 6

The buyer of an American-style bond call option has the right, but not the obligation, to sell the bond at a set price until the option expires.

Question 7

A bank has a positive repricing gap and wishes to protect its profits from an unfavorable interest rate move. Purchasing a cap will help limit this bank's interest rate risk.

Question 8

A bank with a negative repricing gap could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest to effectively reduce its repricing gap.

Question 9

A U.S. corporation has a yen-denominated loan it must repay in 6 months. A long position in yen futures could help offset the corporation's foreign exchange risk.

Question 10

A purchaser of a bond call option gains if interest rates fall.

Question 11

As interest rates fall, bond prices and call option potential profits increase.

Question 12

Buying a cap is similar to buying a call option on bond prices.

Question 13

Swaps and forwards are subject to contingent risk; exchange-traded futures and options are not.

Question 14

A macro hedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable.

Question 15

Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another.

Question 16

An FI with D_A < kD_L may choose to enter into a long-term swap where it pays a fixed rate of interest and receives a variable rate in order to effectively reduce the duration gap.

Question 17

The maximum gain (ignoring commissions and taxes) from buying an at-the-money bond put option is the bond price at time of option purchase less the put premium. The maximum loss is the put premium.

Question 18

Gains and losses on a futures contract must be recognized daily.

Question 19

Writing a call option on a bond pays off if interest rates rise.

Question 20

A fixed-floating interest rate swap is called a plain vanilla swap.

Question 21

For a bond put option, the _____ the exercise price, the greater the cost of the put, and for a bond call option, the _____ the exercise price, the higher the cost of the call option.

A) higher; higher
B) lower; lower
C) higher; lower
D) lower; higher

Question 22

An FI with D_A > kD_L could do which of the following to reduce the duration gap?

A) Engage in a swap and pay a variable rate and receive a fixed rate of interest
B) Sell bond futures contracts
C) Buy bonds forward
D) Buy bond call options
E) None of the above

Question 23

A bond portfolio manager has a $25 million market value bond portfolio with a 6-year duration. The manager believes interest rates may increase 50 basis points. Which of the following could be used to help limit his risk?
I) Sell the bonds forward.
II) Buy bond futures contracts.
III) Buy call options on the bonds.
IV) Buy put options on the bonds.

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

Question 24

The price of a bond rises from 98 to par. Even if you do nothing, this would still result in an immediately recognized loss on a _____________ on a bond, and a paper gain on a bond ______________.

A) long forward contract; call option
B) short futures contract; call option
C) call option; put option
D) short futures contract; put option
E) short forward contract; call option

Question 25

A _____ position in T-bond futures should be used to hedge falling interest rates and a _____ position in T-bond futures should be used to hedge falling bond prices.

A) long; short
B) long; long
C) short; long
D) short; short

Question 26

If we were to design a macrohedge, which of the following positions would help reduce the bank's interest rate risk?
I) Long position in bond futures contracts
II) Buying put options on bonds
III) Purchasing an interest rate cap

A) I only
B) II only
C) III only
D) I and III only
E) II and III only Risk is from falling interest rates or rising prices with a positive repricing gap.

Question 27

Basis risk occurs because it is generally impossible to

A) hedge unanticipated rate changes.
B) exactly predict interest rate changes.
C) exactly match the terms of the hedging instrument with the terms of the asset or liability at risk.
D) find negatively correlated asset prices.
E) all of the above

Question 28

A microhedge is a

A) hedge of a particular asset or liability.
B) hedge against a change in a particular macro variable.
C) hedge of an entire balance sheet.
D) hedge using options.
E) hedge without basis risk.

Question 29

The safest way to hedge a bond liability with options is to

A) purchase a call option on the bond.
B) write a call option on the bond.
C) purchase a put option on the bond.
D) write a put option on the bond.

Question 30

A macrohedge is a

A) hedge of a particular asset or liability.
B) hedge of an entire balance sheet.
C) hedge using options.
D) hedge without basis risk.
E) hedge using futures on macroeconomic variables.

Question 31

The largest two categories of swaps are

A) credit risk and interest rate swaps.
B) currency and commodity swaps.
C) interest rate and currency swaps.
D) equity and interest rate swaps.
E) none of the above

Question 32

A forward contract

A) is marked to market.
B) has significant default risk.
C) is standardized.
D) is traded over the counter.
E) is highly liquid.

Question 33

An FI has long-term, fixed-rate assets funded by short-term, variable-rate liabilities. To protect the equity value, the FI may engage in a swap to pay a _____ rate and receive a _____ interest.

A) fixed; variable
B) variable; variable
C) variable; fixed
D) fixed; fixed

Question 34

Which of the following bond option positions increase in value when interest rates increase?

A) Long call; written put
B) Long put; written call
C) Long put; long call
D) Written put; written call

Question 35

Which of the following requires daily cash flow settlements between the parties?

A) Forward contract
B) Futures contract
C) Purchased options contract
D) Swap contract
E) Collars

Question 36

The profits on a derivatives position are fixed when a bond's price falls below a certain point, but above that point the profits fall when the bond price rises. This profit profile fits which of the following positions?

A) Purchased call option
B) Written call option
C) Purchased put option
D) Written put option

Question 37

Plain vanilla interest rate swaps are exchanges of

A) principle only.
B) interest only.
C) principle and interest.
D) principle and currency.
E) interest rate and currency.

Question 38

Which of the following are potentially subject to risk-based capital requirements?

A) Swaps and futures
B) Swaps and forwards
C) Forwards and futures
D) Purchased option positions and futures
E) Purchased option positions and swaps

Question 39

A bondholder owns 15-year government bonds with a $5 million face value and a 6% coupon that is paid annually. The bonds are currently priced at $550,018.73 with a yield of 5.034%. The bonds have a duration of 10.53 years. If interest rates are projected to increase by 50 basis points, how much will the bondholder gain or lose?

A) $27,571
B) $25,063
C) -$27,571
D) -$25,063
E) $5,313 $ $\Delta$ P = - Dur x ( $\Delta$ R/(1+R)) x P₀ = -10.53 x (0.0050/1.0534) x 550,018.73= $-27,571

Question 40

The safest way to hedge a bond asset with options is to

A) purchase a call option on the bond.
B) write a call option on the bond.
C) purchase a put option on the bond.
D) write a put option on the bond.

Question 41

Your firm has sold long-term government bonds short on a when-issued basis; your firm must purchase the bonds and deliver them when they are issued in 6 months. To hedge this risk, you could
I) buy at-the-money put options on bonds.
II) sell bond futures contracts.
III) write at-the-money call options on bonds.

A) I only
B) II only
C) I and III only
D) II and III only
E) none of these would hedge the risk The risk is from rising prices.

Question 42

Other than credit risk, what are the risks to the bank?

Question 43

In 2010, only about _____ of the largest banks actively used derivatives.

A) 750
B) 830
C) 940
D) 990
E) 1100

Question 44

A bank wishes to hedge its $25 million face value bond portfolio (currently priced at 106% of par). The bond portfolio has a duration of 5 years. They will hedge with put options that have a delta of 0.67. The bond underlying the option contract has a market value of $112,000 and a duration of 8 years. How many put options are needed? Assume that there is no basis risk on the hedge.

Question 45

What are the advantages and disadvantages of forwards versus futures contracts?

Question 46

A thrift purchases a 1-year interest rate floor with a floor rate of 4.23% from a large bank. The option has a notional principle of $1 million and costs $2,000. If in one year, interest rates are 3%, the thrift's net profit, ignoring commissions and taxes was _____ and if in one year, interest rates were 2%, the thrift's net profit was _____.

A) $0; $7,500
B) $8,800; -$2,000
C) $8,800; $0
D) $29,500; -$2,000
E) $29,500; $0 Max [(Floor rate - Actual rate) x NP, 0] - 2,000 = ((4.23%-3.15%) x $1 million) - 2,000 = $8,800; $0

Question 47

Suppose the institution wishes to fully hedge the interest rate risk with a swap. A swap is available with whatever notional principle is needed that pays fixed at 4.95% and pays variable at LIBOR. LIBOR is currently 5.11%. By how much would profits change right now if the bank engages in the swap?

A) $202,600
B) -$202,600
C) $300,000
D) -$195,200
E) $195,200 Pay variable, receive fixed; (322-200) x (4.95% - 5.11%) = -$195,200

Question 48

A naïve hedge is one

A) where the hedger is not fully informed.
B) where the hedger attempts to eliminate all of the risk of the underlying spot position.
C) where the hedger uses microhedges rather than macrohedges to limit risk.
D) where the hedger unwittingly increases the risk of the FI's position.
E) that does not have to be reported on the FI's financial statements.

Question 49

An FI has D_A = 2.45 years and kD_L = 0.97 years. The FI has total assets equal to $375 million. The FI wishes to effectively reduce the duration gap to one year by hedging with T-Bond futures that have a market value of $115,000 and a D_Fut = 8 years. How many contracts are needed and should the FI buy or sell them? (D = Duration)

Question 50

A regional bank negotiates the purchase of a one-year interest rate cap with a cap rate of 5.45% with a large bank. The option has a notional principle of $2 million and costs $3,400. In one year, interest rates are 6.33%. The regional bank's net profit, ignoring commissions and taxes, was

A) $105,600.
B) $18,400.
C) $17,600.
D) $14,200.
E) $11,500. Max [(Actual rate - Cap rate) x NP, 0] - 3,400 = ((6.33% - 5.45%) x 2M) - 3,400 = $14,200

Question 51

If the bank wishes to set up a swap to totally hedge the interest rate risk, the bank should

A) pay a variable rate of interest and receive a fixed rate of interest.
B) pay a fixed rate of interest and receive a variable rate of interest.
C) pay a variable rate of interest and receive a variable rate of interest.
D) pay a fixed rate of interest and receive a fixed rate of interest. Risk is from falling interest rates or rising prices with a positive repricing gap.

Question 52

A U.S. corporation is bidding on a revenue-generating contract in England. If the corporation gets the bid, they will be paid in pounds. A) If the managers are risk averse, can hedging increase the likelihood that the U.S. firm gets the bid? Explain. B) In this situation, should the corporation hedge with options, futures, or forwards? Explain.

Question 53

A U.S. firm is earning British pounds from its foreign subsidiary. A U.K. firm is earning dollars from its U.S. subsidiary. Neither firm can borrow at a cost-effective rate outside of its home country/currency. What kind of swap could be used to limit the FX risk of both firms and explain the payment flows involved (be specific)?

Question 54

The primary federal banks regulators have established guidelines for derivatives usage at banks including:
I) banks must establish internal guidelines regarding hedging activity.
II) banks must establish trading limits.
III) banks are prohibited from using derivatives to speculate.
IV) banks must disclose large derivatives positions that may materially affect stakeholders in their financial statements.

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

Question 55

Is it safer to hedge a contingent liability with options, futures, forwards, or swaps? Explain.

Question 56

In terms of direct costs, are futures or options likely to be a more expensive form of hedging? Why? In terms of opportunity costs, which is more expensive? Why?

Question 57

A bank wishes to hedge its $30 million face value bond portfolio (currently priced at 99% of par). The bond portfolio has a duration of 9.75 years. They will hedge with T-Bond futures ($100,000 face) priced at 98% of par. The duration of the T-Bonds to be delivered is 9 years. How many contracts are needed to hedge? Should the contracts be bought or sold? Ignore basis risk.

Question 58

Why is the credit risk on a plain vanilla interest rate swap generally less than the credit risk of a loan with an equivalent (notional) principle amount?

Question 59

Design a swap that the bank could use to reduce their risks.

Question 60

Draw a graph of the gains and losses from owning a bond and simultaneously buying a put on the bond.

Question 61

A bank wishes to reduce its duration gap from 1.2 years to zero by using put options. The bank has $800 million in assets. The underlying bonds on the puts are valued at $115,000 and have a duration of 4 years. The put options have a delta of 0.58. How many put options are needed? Assume that there is no basis risk on the hedge.

Question 62

A $995 million bank has a negative repricing gap equal to 6% of assets. The bank is currently paying 4.5% on its rate-sensitive liabilities. These rates will vary as interest rates move. The managers wish to reduce the effective repricing gap to zero with an interest rate cap or floor. A one-year cap is available with a 5% cap rate and a one-year floor is available at a floor rate of 4%.
a) Suggest a position using either the cap or the floor (but not both) that will limit the bank's interest rate risk. Explain.
b) Suppose that interest rates are volatile this year and the cap costs $275,000 and the floor costs $195,000. Suggest a collar that helps limit the bank's cost of hedging. How does the collar affect the bank's risk?