Question 1

Users of commodities are:
A)Usually not participants in futures contracts.
B)Speculators preferring to get the large returns which result from large risk.
C)Likely to take the short position in a futures contract.
D)Buyers of futures.

Accepted Answer

Users of commodities are typically buyers of futures contracts as they are looking to hedge against future price fluctuations or secure a steady supply of a commodity at a fixed price.

Question 2

A baker of bread has a long-term fixed-price contract to supply bread.Which of the following would NOT reduce her risk?
A)Taking the long position in wheat futures contract.
B)Hedging this risk in the wheat futures market.
C)Finding a wheat farmer who will take the short position in a wheat futures contract.
D)Finding a wheat farmer who will take the long position in a wheat futures contract.

Accepted Answer

If the baker finds a wheat farmer who will take the long position in a wheat futures contract, this would not reduce her risk because the farmer is betting on the price of wheat to increase, which would result in higher costs for the baker. The other options, A, B, and C, would all help to reduce the baker's risk by allowing her to lock in a price for wheat or transfer the risk to someone else.

Question 3

A pension fund manager who plans on purchasing bonds in the future:
A)Wants to insure against the price of bonds falling.
B)Can offset the risk of bond prices rising by selling a futures contract.
C)Will take the long position in a futures contract.
D)Will take the short position in a futures contract.

Accepted Answer

A pension fund manager planning to purchase bonds in the future would take a long position in a futures contract to hedge against the risk of bond prices rising.

Question 4

A U.S.Treasury bond dealer who sells a futures contract for U.S.Treasury bonds is:
A)Taking on additional risk in hopes of getting a larger return.
B)Ensuring the sales price of the bond through hedging.
C)Not likely to find a buyer for this transaction.
D)Should see the value of the futures contract increase as bond prices rise.

Accepted Answer

By selling a futures contract for U.S. Treasury bonds, the bond dealer is hedging their position and ensuring the sales price of the bond. This helps to mitigate the risk of changes in interest rates and fluctuations in bond prices. Therefore, option B is the correct answer. Option A is incorrect because selling a futures contract does not necessarily involve taking on additional risk. Option C is incorrect because futures contracts are highly liquid and can easily be bought and sold. Option D is incorrect because the value of the futures contract will decrease as bond prices rise.

Question 5

The clearing corporation's main role in the futures market is to:
A)Set the market price of the contract.
B)Act as the counterparty to both sides of the transaction, thereby guaranteeing payment.
C)Provide the underlying assets so the contracts can be created.
D)All of the above.

Accepted Answer

The main role of a clearing corporation in the futures market is to act as the counterparty to both sides of the transaction, thereby ensuring that payment is guaranteed. It doesn't set the market price of a contract, neither it provides the underlying assets for creating contracts. So, option A and C are incorrect. Option D is therefore incorrect as well.

Question 6

Forward contracts are:
A)An agreement between more than two parties.
B)Contracts usually involving the exchange of a commodity or financial instrument.
C)Always standardized.
D)Easily resold.

Accepted Answer

Forward contracts are agreements between two parties to buy or sell an underlying asset at a future date and a predetermined price. They are usually used to hedge against future price fluctuations of commodities or financial instruments, such as currencies, stocks, or bonds. They are not standardized and cannot be resold easily.

Question 7

With a futures contract:
A)Payment is made when the contract is created.
B)No payment is made until the settlement date.
C)The short position agrees to purchase the underlying asset.
D)The risk is eliminated for both parties.

Accepted Answer

In a futures contract, payment is not made when the contract is created. Instead, payment is typically made on the settlement date, which is the future date specified in the contract when the underlying asset will be delivered or settled. The short position does not agree to purchase the underlying asset; rather, they agree to sell it at a future date. The risk is not eliminated for both parties, as both the long and short positions are exposed to market movements that could result in either gains or losses.

Question 8

In a derivative transaction:
A)The dollar amount of the transaction increases as the contract date approaches.
B)The risk is less than if actually purchasing the underlying asset.
C)What one person gains is what the other person loses.
D)There is always a futures contract.

Accepted Answer

In a derivative transaction, one party gains only if the other party loses. Derivatives contracts involve no inherent value on their own; their value is derived from an underlying asset like stocks or commodities. Therefore, the buyer hopes that the price of the underlying asset will increase, while the seller hopes that it will decrease. This means that in a derivative transaction, one party's gain is necessarily equal to the other party's loss.

A, B, and D are all incorrect. The dollar amount of the derivative transaction can increase or decrease depending on market conditions, and the risk of a derivative transaction can be higher than buying the underlying asset if not properly managed. Also, a derivative transaction doesn't need to involve a futures contract; it can be any type of financial instrument that derives its value from an underlying asset.

Question 9

The long position in a futures contract is the party that will:
A)Benefit from decreases in the price of the underlying asset.
B)Agree to make delivery of a commodity or financial instrument at a future date.
C)Benefit from increases in the price of the underlying asset.
D)Accept the greater share of the risk.

Accepted Answer

A long position in a futures contract is taken by a party who expects the price of the underlying asset to increase. Therefore, they benefit from increases in the price of the underlying asset.

Question 10

Derivatives are financial instruments that:
A)Present high levels of risk and should only be used by the wealthy.
B)When used correctly can actually lower risk.
C)Should only be used by people seeking high returns from low risk.
D)Represents the outright purchase of a bond.

Accepted Answer

Derivatives, when used correctly, can actually lower risk by allowing investors to hedge against potential losses. However, if used improperly or in excess, they can present high levels of risk. Choice A is incorrect as derivatives should not be limited to only the wealthy, but instead should be used prudently by any investor. Choice C is incorrect as derivatives are not low risk investments and should only be used by individuals who understand their risks. Choice D is incorrect as derivatives do not represent the outright purchase of a bond, but rather are contracts based on the value of underlying assets such as bonds, stocks, or commodities.

Question 11

Speculators differ from hedgers in the sense that:
A)Speculators do not like risk.
B)Hedgers seek to transfer risk.
C)Speculators seek to transfer risk.
D)Speculators are hedgers, there isn't any difference.

Accepted Answer

Hedgers seek to transfer risk to protect themselves from price fluctuations, while speculators take on risk in hopes of making a profit.

Question 12

The process of marking to market:
A)Is done by the clearing corporation to reduce risk in futures contracts.
B)Involves the margin accounts of only the buyers of future contracts.
C)Involves the margin accounts of only the sellers of future contracts.
D)Usually requires margin accounts to be adjusted weekly by the clearing corporation.

Accepted Answer

The process of marking to market is done by the clearing corporation to reduce risk in futures contracts. This involves adjusting margin accounts both for the buyers and sellers of futures contracts. The purpose of this process is to ensure that both parties have enough funds to cover potential losses and maintain a balance in the market. The clearing corporation typically performs this process daily or multiple times a day to reflect changes in market values.

Question 13

The short position in a futures contract is the party that will:
A)Deliver a commodity or financial instrument to the buyer at a future date.
B)Suffer the loss.
C)Accept the risk.
D)Benefit from increases in price of the underlying asset.

Accepted Answer

The short position in a futures contract is obligated to deliver the underlying commodity or financial instrument to the buyer at a future date.

Question 14

The value of a derivative is determined by:
A)The Federal Reserve.
B)SEC regulation.
C)The value of the underlying asset.
D)The risk-free rate.

Accepted Answer

The value of a derivative is primarily determined by the underlying asset, such as a stock or commodity, and how it performs in the market. Other factors, such as interest rates and volatility, can also impact the value of derivatives, but the underlying asset is the biggest determinant. The Federal Reserve and SEC regulation may affect the overall market, but they do not directly influence the value of a specific derivative. The risk-free rate is a factor in determining the price of derivatives, but it is not the primary determinant.

Question 15

The key difference between a forward and a futures contract is:
A)A forward contract is customized where a futures contract is not.
B)A forward contract is bought and sold on organized exchanges.
C)Only the forward contracts have settlement dates.
D)The amount of time involved.

Accepted Answer

A forward contract is typically customized to meet the specific needs of the buyer and seller, whereas a futures contract is standardized and traded on organized exchanges. This customization in a forward contract also means that there may not be as much liquidity and transparency as there is in a futures market. The other answer choices (B, C, and D) are incorrect because they do not accurately describe the key difference between these two types of contracts.

Question 16

There is a futures contract for the purchase of 1000 bushels of corn at $3.00 per bushel.If the market price of corn falls to $2.50:
A)The buyer (long position) needs to transfer $500 to the seller (short position).
B)The seller (long position) needs to transfer $500 to the buyer (short position).
C)Nothing happens since marked to market adjustments only occur if the market price rises above the contract price.
D)Nothing happened since no funds are transferred until the settlement date.

Accepted Answer

When the market price of corn falls to $2.50, the contract price is now greater than the market price. As such, the buyer (long position) needs to make a marked to market adjustment and transfer $500 to the seller (short position). This is because the contract requires the buyer to purchase corn at the agreed-upon price, even if the market price has fallen. The marked to market adjustment ensures that both parties uphold their end of the contract and reduces the risk of default.

Question 17

A wheat farmer who must purchase his inputs now but will sell his wheat at a market price at a future date:
A)Faces a market risk that cannot be offset.
B)Is a good example of what the chapter refers to as a speculator.
C)Would hedge by taking the short position in a wheat futures contract.
D)Would hedge by taking the long position in a wheat futures contract.

Accepted Answer

The farmer can hedge against the risk of falling wheat prices by taking a short position in a wheat futures contract, which locks in a selling price for the wheat at a future date.

Question 18

There is a futures contract for the purchase of 100 bushels of wheat at $2.50 per bushel.If the market price of wheat increases to $3.00 per bushel:
A)The buyer (long position) needs to transfer $50 to the seller (short position).
B)The seller (short position) needs to transfer $50 to the buyer (long position).
C)Nothing happens since with a futures contract all payments are made at the settlement date.
D)Nothing happens since marked to market adjustments only take place when the market price falls below the contract price.

Accepted Answer

If the market price of wheat increases to $3.00 per bushel, the buyer (long position) can sell the futures contract at this higher price and make a profit of $0.50 per bushel ($3.00 - $2.50). This profit is paid by the seller (short position), who would need to transfer $50 ($0.50 × 100 bushels) to the buyer (long position). This process is called marking to market, which is a daily settlement of the gains and losses in a futures contract based on the current market price.

Question 19

The purpose of derivatives is to:
A)Increase the risk so the return is larger.
B)Eliminate risk for both parties in the transaction.
C)Postpone the risk for both parties in the transaction.
D)Transfer the risk from one person to another.

Accepted Answer

The purpose of derivatives is to transfer the risk from one person to another. It allows one party to take on a particular risk while the other party is protected from that risk. This can be beneficial for both parties as it allows them to manage their risks more effectively. However, it can also increase the overall level of risk in the financial system if not managed properly.

Question 20

Marking to market is a process that:
A)Involves a transfer of risk.
B)Ensures that the buyers and sellers receive what the contract promises.
C)Always requires the sellers of contracts to transfer funds to the buyers of contracts.
D)Buyers and sellers can request for an additional fee when the contract is created.

Accepted Answer

Marking to market refers to the process of adjusting the value of a financial instrument to reflect the current market value. This ensures that buyers and sellers receive what the contract promises and eliminates the risk of default by either party. It does not always require transfer of funds, nor is it an option that buyers and sellers can request for an additional fee. Instead, the adjustment of the contract value occurs automatically based on changes in the market value.

Quiz 9: Derivatives: Futures, Options, and Swaps

Users of commodities are:

A baker of bread has a long-term fixed-price contract to supply bread.Which of the following would NOT reduce her risk?

A pension fund manager who plans on purchasing bonds in the future:

A U.S.Treasury bond dealer who sells a futures contract for U.S.Treasury bonds is:

The clearing corporation's main role in the futures market is to:

Forward contracts are:

With a futures contract:

In a derivative transaction:

The long position in a futures contract is the party that will:

Derivatives are financial instruments that:

Speculators differ from hedgers in the sense that:

The process of marking to market:

The short position in a futures contract is the party that will:

The value of a derivative is determined by:

The key difference between a forward and a futures contract is:

There is a futures contract for the purchase of 1000 bushels of corn at $3.00 per bushel.If the market price of corn falls to $2.50:

A wheat farmer who must purchase his inputs now but will sell his wheat at a market price at a future date:

There is a futures contract for the purchase of 100 bushels of wheat at $2.50 per bushel.If the market price of wheat increases to $3.00 per bushel:

The purpose of derivatives is to:

Marking to market is a process that: