Question 1

You are a financial manager with JCN,Co.and you have used a forward contract to hedge a yen 100,000,000 payment the company expects to receive in 90 days.Your contract calls for you to deliver yen at 109.75 yen per U.S.dollar.Suppose the spot rate at that time is 111.25 yen per U.S.dollar.Did you gain or lose on the hedge? How much?

Accepted Answer

We use the following formula to calculate the gain or loss on the hedge:
Gain or loss = (Forward rate - Spot rate) x Payment amount / Forward rate
Plugging in the given values, we get:
Gain or loss = (109.75 - 111.25) x 100,000,000 / 109.75
Gain or loss = -1.37% x 100,000,000 / 109.75
Gain or loss = -JPY 1,249,999.95
Converting this to USD using the spot rate, we get:
Gain or loss = -JPY 1,249,999.95 / 111.25 = -$11,214.67
Since the amount is negative, the company experienced a loss on the hedge. The closest answer is C, which states a gain of $12,285.33, but that is incorrect.

Question 2

Use the following information on CBOE 13-week T-bill rate options to answer the following question(s).
 
-Refer to CBOE.What is the cost of the least expensive floor to protect from falling interest rates?

Accepted Answer

A

Question 3

Outsource,Inc.expects a payment from a French customer in thirty days.To hedge its currency exposure,Outsource should

Accepted Answer

By selling euros forward, Outsource can lock in the current exchange rate and ensure that they will receive the same amount of dollars regardless of any fluctuations in the currency market over the next thirty days. This will help to mitigate their currency exposure risk.

Question 4

If the spot exchange rate is 110 yen per U.S.dollar,the "fair" forward exchange rate is 115 yen per U.S.dollar,and the risk-free borrowing rate in the United States is 2.5%,what must the risk-free borrowing rate be in Japan?

Accepted Answer

The forward exchange rate can be calculated using the interest rate parity formula: Forward Rate = Spot Rate * (1 + interest rate of domestic currency) / (1 + interest rate of foreign currency). Solving for the Japanese interest rate, we get: 115 = 110 * (1 + 0.025) / (1 + r). Solving for r gives approximately 7.2%.

Question 5

A standard "fixed for floating" interest rate swap contract is effectively

Accepted Answer

A standard "fixed for floating" interest rate swap is a contract where one party agrees to pay a fixed interest rate to another party, while receiving a floating interest rate in return. This can be thought of as a series of forward rate agreements, where each exchange of payments represents a forward rate agreement for a future period of time. It is not a series of call or put options, as the parties are obligated to make the agreed upon payments, regardless of the direction of interest rates.

Question 6

The spot rate on the British pound is 0.5491 per U.S.dollar,while the risk-free borrowing rates are 4% in Britain and 3% in the United States.What is the "fair" forward exchange rate?

Accepted Answer

To calculate the fair forward exchange rate, we need to use the interest rate parity formula:

Forward rate = Spot rate × (1 + foreign interest rate) / (1 + domestic interest rate)

Plugging in the numbers, we get:

Forward rate = 0.5491 × (1 + 0.04) / (1 + 0.03) = 0.5544 pounds per dollar

Therefore, the correct answer is D.

Question 7

Which of the following is a (are)key difference(s)a manager should note in choosing between forward and futures contracts?

Accepted Answer

The key difference between forward and futures contracts is that futures contracts have standardized terms, while forward contracts can be customized to meet specific needs. This means that managers can tailor forward contracts to their specific requirements, while futures contracts are more generic in nature. Exchange trading does not necessarily make forward contracts more liquid, as liquidity depends on the specific market conditions and demand for the contract. Default risk may also be similar for both types of contracts, depending on the creditworthiness of the counterparties involved. While forward contracts may require initial margin deposits and daily marking to market, futures contracts also typically require margin deposits and are subject to daily settlement procedures.

Question 8

Why might a financial manager prefer using option contracts instead of futures or forward contracts to hedge?

Accepted Answer

Option contracts provide the financial manager with protection against adverse price movements, while still allowing them to benefit from favorable price movements. Futures and forwards require a premium to be paid upfront and create an obligation to perform, while options do not have this obligation. All three instruments have default risk, but futures and forwards may have greater default risk than options.

Question 9

The MakeStuff Company's earnings stream is highly dependent on the cost of a key commodity input. Management believes taxable earnings will be $100,000 if the input price is low, taxable earnings will be $50,000 if the input price is at a moderate level, but earnings will be zero if the input price is high. Management sees these outcomes as being equally likely. The company pays a 15% tax rate on the first $50,000 of taxable earnings, and a 25% rate on all earnings above $50,000.
-What is MakeStuff's tax liability if the input price is at the moderate level?

Accepted Answer

If the input price is at a moderate level, taxable earnings are $50,000. The tax rate on the first $50,000 is 15%, so the tax liability is $50,000 * 0.15 = $7,500.

Question 10

Use the following information on CBOE 13-week T-bill rate options to answer the following question(s).
 
-Refer to CBOE.Suppose you want to construct a collar to reduce the cost of the cap by selling a floor.What is the net cost of the least expensive such collar? (Be sure the strike prices on the call and the put are NOT the same!)

Accepted Answer

The answer of Use the following information on CBOE 13-week...

Question 11

Suppose the spot exchange rate is 0.5491 pounds per U.S.dollar,while the risk-free borrowing rate is 4% in Britain.If the "fair" exchange rate is 0.5544 pounds per U.S.dollar,what is the risk-free borrowing rate in the United States?

Accepted Answer

The answer of Suppose the spot exchange rate is 0.5491...

Question 12

Use the following information on CBOE 13-week T-bill rate options to answer the following question(s).
 
-Refer to CBOE.If you used the OCT 35 option to hedge rising rates,and the yield to maturity (YTM)on 13-week bills is 3.75 percent at the option's expiration,what is the outcome of your hedge?

Accepted Answer

The answer of Use the following information on CBOE 13-week...

Question 13

You are a financial manager with ICN,Co.and you have used a forward contract to hedge a yen 100,000,000 payment the company expects in 90 days.Your contract calls for you to deliver yen at 111.25 yen per U.S.dollar.Suppose the spot rate at that time is 109.75 yen per U.S.dollar.Did you gain or lose on the hedge? How much?

Accepted Answer

The forward contract locks in a rate of 111.25 yen per dollar, but the spot rate is 109.75 yen per dollar. This means you are paying more yen per dollar than the market rate, resulting in a loss. The loss is calculated as (111.25 - 109.75) yen per dollar * (100,000,000 yen / 111.25 yen per dollar) = $12,285.33.

Question 14

Which of the following is NOT a motivation for hedging?

Accepted Answer

Hedging is primarily used to manage risk, not to offset the costs of insurance. It involves using financial instruments to reduce exposure to various risks (e.g., currency, interest rate, commodity price risks). The other options (A, B, D) are indeed motivations for hedging, as they relate to reducing financial distress, improving managerial performance evaluation, and managing tax liabilities.

Question 15

Use the following information on CBOE 13-week T-bill rate options to answer the following question(s).
 
-Refer to CBOE.Suppose you want to cap your interest rate before a planned October borrowing.What is the cost of using the OCT 35 option to hedge?

Accepted Answer

Based on the information provided in the CBOE table, the OCT 35 call option has a premium of 1.20. This means that for each contract purchased, the cost of hedging against potential interest rate increases is $120. Therefore, the answer is C) $120 per contract.

Question 16

The Exim Company has entered into a 3 month,$250 notional principal forward rate agreement (FRA)with What-a-Bank.The terms are such that Exim will pay What-a-Bank if LIBOR is above 2%,but What-a-Bank will pay Exim if LIBOR is below 2%.Based on the standard FRA formula,who will pay and how much,if LIBOR is 2.375% in three months?

Accepted Answer

Since LIBOR is above 2% at 2.375%, Exim Co. will pay What-a-Bank. The payment amount is calculated using the FRA formula, which takes into account the difference between the agreed rate and the actual LIBOR rate, the notional principal, and the duration of the agreement. The specific calculation details are not provided, but based on the given options, when Exim Co. is the payer due to the higher LIBOR, the correct amount is $232,992.

Question 17

The Exim Company has entered into a 3 month,$250 million notional principal forward rate agreement (FRA)with What-a-Bank.The terms are such that Exim will pay What-a-Bank if LIBOR is above 2%,but What-a-Bank will pay Exim if LIBOR is below 2%.Based on the standard FRA formula,who will pay and how much,if LIBOR is 1.625% in three months?

Accepted Answer

Since LIBOR is below 2% at 1.625%, What-a-Bank will pay Exim. The payment is calculated using the FRA formula: $$Payment = \frac{Notional \times (Agreed\ Rate - LIBOR) \times Days}{36000}$$. Substituting the given values: $$Payment = \frac{$250,000,000 \times (2\% - 1.625\%) \times 90}{36000} = $233,427.$$

Question 18

The MakeStuff Company's earnings stream is highly dependent on the cost of a key commodity input. Management believes taxable earnings will be $100,000 if the input price is low, taxable earnings will be $50,000 if the input price is at a moderate level, but earnings will be zero if the input price is high. Management sees these outcomes as being equally likely. The company pays a 15% tax rate on the first $50,000 of taxable earnings, and a 25% rate on all earnings above $50,000.
-What is MakeStuff's after-tax earnings if it can lock in the moderate price level for sure?

Accepted Answer

If the input price is at a moderate level, taxable earnings will be $50,000. With a 15% tax rate on the first $50,000, MakeStuff will pay $7,500 in taxes. Therefore, their after-tax earnings would be $42,500 ($50,000 - $7,500). This is the best choice because it is a guaranteed outcome, with no risk involved. The other outcomes involve high levels of uncertainty and could result in significantly lower earnings or no earnings at all.

Question 19

Suppose rising gas prices cut into consumer spending,and Wal-mart,Target,and other retailers experience a slow-down in sales.This slow-down is an example of

Accepted Answer

The answer of Suppose rising gas prices cut into consumer...

Question 20

The MakeStuff Company's earnings stream is highly dependent on the cost of a key commodity input. Management believes taxable earnings will be $100,000 if the input price is low, taxable earnings will be $50,000 if the input price is at a moderate level, but earnings will be zero if the input price is high. Management sees these outcomes as being equally likely. The company pays a 15% tax rate on the first $50,000 of taxable earnings, and a 25% rate on all earnings above $50,000.
-What is MakeStuff's expected after tax earnings if it remains unhedged?

Accepted Answer

The expected taxable earnings are calculated as the average of the three scenarios: $(100,000 + 50,000 + 0) / 3 = $50,000. For the first $50,000, the tax is 15%, which is $7,500. For earnings above $50,000 (which only applies to the $100,000 scenario), the additional $50,000 is taxed at 25%, which is $12,500. So, the total tax on $100,000 is $7,500 + $12,500 = $20,000, leaving $80,000 after tax. The expected after-tax earnings are the average of the three scenarios: $(80,000 + 42,500 + 0) / 3 = $40,833.

Quiz 23: Risk Management

Use the following information on CBOE 13-week T-bill rate options to answer the following question(s) . -Refer to CBOE.What is the cost of the least expensive floor to protect from falling interest rates?