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.

Accepted Answer

Basis risk arises because the price of the futures contract and the price of the underlying asset being hedged do not move perfectly in sync, leading to potential mismatches in value changes.

Question 2

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

Accepted Answer

A hedger with a long spot position should sell futures to reduce their risk, as this hedges against the risk of prices falling.

Question 3

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

Accepted Answer

A pension fund manager would protect recent price gains by selling stock index futures contracts, not buying them. Selling futures contracts can hedge against a decline in the market value of the portfolio.

Question 4

Writing calls can generate potentially unlimited losses.

Accepted Answer

Writing (selling) call options involves the obligation to sell the underlying asset at the strike price if the option is exercised, potentially leading to unlimited losses if the asset's price rises significantly beyond the strike price.

Question 5

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

Accepted Answer

The primary regulator of options contracts in the United States is the Securities and Exchange Commission (SEC), while the Chicago Board Options Exchange (CBOE) is a marketplace where options are traded.

Question 6

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

Accepted Answer

The price sensitivity rule, often used in hedging strategies, helps in estimating the number of futures contracts needed to hedge a position by taking into account the price sensitivity of the spot position relative to the futures position.

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.

Accepted Answer

By buying futures contracts, a hedger can lock in a price for the commodity, thus reducing the risk of price fluctuations in the future.

Question 8

Futures markets involve more standardized contracts compared to forward markets.

Accepted Answer

Futures markets involve contracts that are standardized in terms of quantity, quality, and delivery time, facilitating trading on an exchange. Forward markets, in contrast, involve customized contracts negotiated directly between two parties, tailored to their specific needs.

Question 9

Futures contracts eliminate risk to all participants.

Accepted Answer

Futures contracts do not eliminate risk entirely; they redistribute and manage risk between parties, but each participant still faces market, credit, and operational risks.

Question 10

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

Accepted Answer

A swap is a derivative contract through which two parties exchange financial instruments, typically involving cash flows based on a notional principal amount. It does not involve buying and selling a futures contract simultaneously.

Question 11

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

Accepted Answer

The answer of Margin risk involves the chance that initial...

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.

Accepted Answer

A long financial futures hedger benefits from an increase in the price of the underlying asset because the value of their futures position increases, leading to potential gains when contracts are marked to market.

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.

Accepted Answer

By swapping future fixed rate interest payments for variable rate interest payments, a savings and loan with a negative GAP (more interest rate-sensitive liabilities than assets) can align its interest income with its interest expenses, thereby reducing its exposure to interest rate fluctuations and mitigating its risk.

Question 14

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

Accepted Answer

Open interest refers to the total number of outstanding derivative contracts, such as futures or options, that have not been settled or closed by delivery. It represents the number of contracts that are held by market participants at the end of each trading day.

Question 15

Options premiums vary directly with the maturity of the option.

Accepted Answer

Options premiums typically increase with the maturity of the option because there is a greater chance for the underlying asset to move in a favorable direction, thus increasing the potential for profit.

Question 16

Most forward market contracts are settled before delivery.

Accepted Answer

The answer of Most forward market contracts are settled before...

Question 17

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

Accepted Answer

Margin requirements in futures trading act as a form of security deposit, ensuring that traders have enough capital to cover potential losses, thereby reducing the risk of default.

Question 18

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

Accepted Answer

Portfolio insurance with stock index futures is used to hedge against market risk (systematic risk), not to eliminate unsystematic risk, which is specific to individual stocks or sectors.

Question 19

Cross-hedgers involve more basis risk than direct hedges.

Accepted Answer

Cross-hedging involves using a contract on one commodity as a hedge for another commodity, which typically results in more basis risk due to the lack of a perfect correlation between the price movements of the two commodities.

Question 20

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

Accepted Answer

By selling Eurodollar futures, a depository institution can lock in the cost of borrowing funds in the future, thus reducing the variability of its cost of funds due to interest rate fluctuations.

Quiz 11: Derivatives Markets