Question 1

A macrohedge is a

Accepted Answer

A macrohedge involves hedging an entire balance sheet rather than just a particular asset or liability. This approach aims to protect against overall changes in market conditions or macroeconomic variables rather than specific risks associated with individual investments.

Question 2

Basis risk occurs because it is generally impossible to

Accepted Answer

Basis risk arises when the hedging instrument does not perfectly match the terms of the asset or liability being hedged, leading to some degree of uncertainty in the effectiveness of the hedge. While it is true that it is generally impossible to predict interest rate changes with complete accuracy, this is not the primary driver of basis risk. Similarly, finding negatively correlated asset prices would help to diversify risk, but it does not directly address basis risk.

Question 3

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.

Accepted Answer

For a bond put option, a higher exercise price means the option is more valuable, hence more costly, because it allows selling the bond at a higher price. For a bond call option, a lower exercise price makes the option more valuable, hence more costly, because it allows buying the bond at a lower price.

Question 4

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?

Accepted Answer

A written call option fits this profit profile because the writer (seller) of the call option has a fixed profit when the bond's price is below the strike price (since the option is not exercised), but above that point, as the bond price rises, the profits for the call writer decrease because they have to sell the bond at the strike price, which is lower than the market price.

Question 5

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 ________.

Accepted Answer

A rise in the bond price from below par to par would result in a loss on a short futures contract because the holder of a short position would have been better off selling at the higher price. Conversely, it would result in a gain on a call option because the option to buy at a lower price becomes more valuable as the market price increases.

Question 6

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

Accepted Answer

Futures contracts require daily cash flow settlements, also known as margin calls, between the parties to ensure that both parties have the necessary funds to fulfill their obligations under the contract. The other options listed do not require daily settlements.

Question 7

A bond portfolio manager has a $25 million market value bond portfolio with a six-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.

Accepted Answer

Selling the bonds forward would lock in an interest rate now and may limit upside potential. Buying bond futures contracts or put options on the bonds would protect against rising interest rates by allowing the manager to sell the bonds at a higher price if rates increase, while buying call options on the bonds would not provide downside protection if rates decrease. Therefore, options would not be the best choice, and the most effective strategy would be to buy put options on the bonds or selling the bonds forward.

Question 8

A bondholder owns 15-year government bonds with a $5 million face value and a 6 percent coupon that is paid annually. The bonds are currently priced at $550,018.73 with a yield of 5.034 percent. 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?

Accepted Answer

Using the formula for bond price change due to changes in yield:

Bond Price Change = - Duration x ΔYield x Bond Price

where Duration = 10.53 years, ΔYield = 0.005 (50 basis points), and Bond Price = $550,018.73

Bond Price Change = - 10.53 x 0.005 x $550,018.73 = -$28,964.32

Since the question is asking for the gain or loss, we need to take the negative value of the bond price change. Therefore, the bondholder will lose $27,571 (rounded to the nearest dollar) if interest rates increase by 50 basis points. The correct answer is C.

Question 9

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

Accepted Answer

When interest rates increase, the value of bonds decrease. Therefore, a long put option position (which gives the holder the right to sell bonds at a fixed price) and a written call option position (which obligates the writer to sell bonds at a fixed price) will increase in value.

Question 10

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

Accepted Answer

Swaps and forwards are both over-the-counter (OTC) derivatives and are therefore subject to risk-based capital requirements. Forwards and futures are also OTC derivatives, but futures are typically traded on organized exchanges that have their own margin requirements, so they may not be subject to the same risk-based capital requirements as OTC derivatives. Purchased option positions and swaps are also OTC derivatives, but purchased options are typically less risky than swaps and are often used for hedging purposes, so they may not be subject to the same risk-based capital requirements as swaps.

Question 11

The largest two categories of swaps are

Accepted Answer

According to the International Swaps and Derivatives Association (ISDA), the two largest categories of swaps are interest rate swaps and currency swaps. Therefore, option C is the correct answer. Option A is incorrect because while credit risk is a significant consideration in swaps, it is not one of the two largest categories. Option B is incorrect because commodity swaps are a relatively small subset of the overall swaps market. Option D is also incorrect because equity swaps are a smaller category when compared with interest rate and currency swaps.

Question 12

An FI with DA > kDL could do which of the following to reduce the duration gap?

Accepted Answer

Selling bond futures contracts would reduce the duration of the assets, thereby reducing the duration gap.

Question 13

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

Accepted Answer

The safest way to hedge a bond asset is to purchase a put option on the bond. This allows the holder to sell the bond at a predetermined price if its value drops. By doing so, the holder is protected against the downside risk while still allowing for potential upside gains. Writing a call option (option B) on the bond would require the writer to sell the bond at the predetermined price, which can expose them to unlimited potential loss. Purchasing a call option (option A) on the bond would provide protection against downside risk, but would limit potential profit. Writing a put option (option D) on the bond would require the writer to purchase the bond at a predetermined price, which can also expose them to significant potential loss. Therefore, option C is the safest and most appropriate way to hedge a bond asset with options.

Question 14

Plain vanilla interest rate swaps are exchanges of

Accepted Answer

Plain vanilla interest rate swaps involve the exchange of interest payments, not principal, between two parties.

Question 15

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.

Accepted Answer

To protect the equity value, the FI needs to fix the interest rate it pays on its liabilities to match the fixed-rate interest it earns on its assets. Therefore, the FI must engage in a swap to pay a fixed rate and receive a variable interest rate. Thus, choice A is the best option.

Question 16

After conducting a rate-sensitive analysis,a bank finds itself with the following amounts of rate-sensitive assets and liabilities (RSAs and RSL)and fixed-rate assets and liabilities (FRAs and FRLs); the rate of return and cost rates on the accounts are also given:  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

Accepted Answer

The answer of After conducting a rate-sensitive analysis,a bank finds...

Question 17

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.

Accepted Answer

The answer of A ________ position in T-bond futures should...

Question 18

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

Accepted Answer

The answer of The safest way to hedge a bond...

Question 19

A microhedge is a

Accepted Answer

A microhedge aims to hedge against a specific asset or liability, rather than a broader macroeconomic variable or a whole balance sheet.

Question 20

A forward contract

Accepted Answer

The answer of A forward contract
...

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