Deck 24: Risk Management

Question 1

A swap is the arrangement by two counterparties to exchange one stream of cash flows for another.

Answer 1

True

Question 2

Hedging reduces risks and also adds profit to a firm.

Answer 2

False

Question 3

Speculation is foolish unless you have reason to believe that the odds are stacked in your favor.

Answer 3

True

Question 4

Speculators are a necessary component of well-functioning futures markets.

Question 5

An oil producer would sell, rather than buy, crude oil futures for protection from falling prices.

Question 6

Forward contracts are marked to market.

Question 7

While private individuals and firms can hedge risks using options, governments are forbidden from doing so.

Question 8

Futures contracts are custom-tailored forward contracts.

Question 9

A firm might enter a swap contract whereby it agrees to make a series of regular payments in one currency in return for receiving a series of payments in another currency.

Question 10

If you are not better informed than the highly paid professionals in banks and other institutions, you should use derivatives for speculation, not for hedging.

Question 11

Purchasing an insurance policy is one means of reducing risk.

Question 12

It is impossible for a producer who sells put options to lose more than the price of the option premium.

Question 13

Put options can be thought of as insurance policies for commodity producers.

Question 14

Counterparties to an interest rate swap exchange both interest payments and principal amounts.

Question 15

Financial futures contracts are available through the Chicago Board of Trade and the Chicago Mercantile Exchange.

Question 16

Swap contracts can be based on either interest rates or currencies.

Question 17

A survey of the world's 500 largest companies found that the vast majority of the companies use derivatives in some way to manage their risk.

Question 18

Mexico purchased call options to lock in the price of its oil and create a base floor for its revenue stream.

Question 19

Futures contracts are standardized to expire on the same day each year.

Question 20

It is impossible for a producer who sells put options to lose more than the exercise price agreed upon in the option contract.

Question 21

All companies work hard to hedge their exposure to price fluctuations.

Question 22

By using options a firm can protect against increases in raw material prices, while continuing to benefit from price decreases.

Question 23

If you live in certain cities, you can hedge against a change in the price of your home by purchasing a real estate futures contract on the Chicago Mercantile Exchange.

Question 24

Which one of the following is not generally considered a benefit of hedging?

A) Hedging reduces one or more aspects of business risk.
B) Hedging allows prices to be locked in advance.
C) The costs of hedging are paid by the speculators.
D)Hedging can stabilize profits.

Question 25

Which one of the following is not correct concerning futures contracts?

A) Futures contracts entail an obligation rather than an option.
B) The contract price is set at the beginning of the contract.
C) The contracts are exchange-traded.
D)All gains or losses are recorded at contract expiration.

Question 26

The profit to the buyer of a futures contract is equal to the initial futures price minus the ultimate market price.

Question 27

A farmer who sells a futures contract is betting that prices will _____ at the expiration of the contract.

A) decrease
B) increase
C) remain constant
D)guarantee high profits

Question 28

A farmer can avoid delivery on a futures contract by buying an offsetting futures contract.

Question 29

How might a firm such as General Mills use options to control raw material prices for breakfast cereals?

A) Buy call options on commodities
B) Sell call options on commodities
C) Buy put options on commodities
D)Sell put options on commodities

Question 30

Unlike options, the purchase of a futures contract is a binding obligation to purchase at a fixed price at contract maturity.

Question 31

Which one of the following is a source of profit for a swap dealer?

A) Commission charged on the sale of bonds
B) Bid-ask spread
C) Margin account
D)Option premium

Question 32

Both the seller and the buyer in a futures contract are required to put up margins.

Question 33

The derivatives market is characterized by:

A) stability.
B) innovation.
C) predictability.
D)private deals.

Question 34

Exchange traded futures contracts allow the seller to choose the place of delivery for the commodity.

Question 35

Which one of the following futures contracts is written on a nondeliverable asset?

A) U.S. Treasury bills
B) Wheat
C) Standard and Poor's index
D)British pounds

Question 36

A number of copper producers have found that hedging increases their debt capacity.

Question 37

Selling a futures contract may be appropriate for one who wishes to:

A) lock in a future sales price.
B) lock in a future purchase price.
C) speculate that future spot prices are going down.
D)have a ready market in which to sell a product.

Question 38

What form of hedging would you suggest for a producer that wishes to be protected from future price decreases but wants to benefit from any future price increases?

A) Buy a call option on the asset
B) Sell a call option on the asset
C) Buy a put option on the asset
D)Sell a put option on the asset

Question 39

Which one of these firms would probably be most interested in a credit default swap?

A) Corporate farmer
B) Pension fund
C) Portfolio manager
D)Financial institution

Question 40

A hedger who buys a futures contract is betting that prices will _____ at the expiration of the contract.

A) decrease
B) increase
C) remain constant
D)guarantee high profits

Question 41

Which one of the following would not be regulated in a standardized futures contract?

A) Quantity of asset to be traded
B) Quality of asset to be traded
C) The spot price
D)Date of settlement

Question 42

What has happened to cause a $250 loss to be marked to the margin account of a futures contract buyer?

A) The commodity decreased in value on that day.
B) The commodity increased in value on that day.
C) The commodity decreased in value by $250 over the contract's life.
D)The commodity increased in value by $250 over the contract's life.

Question 43

A producer that is worried about the future price that will be available when its product is to be sold can best hedge this price risk by:

A) buying a futures contract.
B) selling a futures contract.
C) buying a call option.
D)selling a call option.

Question 44

The primary purpose of financial futures is to:

A) benefit from increases in interest rates.
B) protect against swings in interest rates or prices of financial assets.
C) translate one currency into another.
D)guarantee the repayment of loan principal.

Question 45

The basic difference between speculators and hedgers in futures contracts is that speculators:

A) will profit regardless of the direction of price change.
B) are not protecting their commodity holdings.
C) are concerned only with long-term price movements.
D)take a position in more than one commodity at a time.

Question 46

What happens to the price of a futures contract as expiration draws closer?

A) The futures price exceeds the spot price of the asset.
B) The futures price is exceeded by the spot price of the asset.
C) The futures price approaches the spot price of the asset.
D)There is no relationship between the futures price and spot price as the contract approaches expiration.

Question 47

You enter into a forward contract to take delivery of 1 million euros 3 months from now. What happens to the price you will pay at expiration if the euro depreciates during the contract period?

A) Your price will increase.
B) Your price will decrease.
C) Your price was fixed at the onset of the contract.
D)Your price was fixed but you will receive correspondingly more euros due to the depreciation.

Question 48

Which one of the following is not correct concerning forward contracts? Forward contracts:

A) are not standardized.
B) do not set the price until the end of the contract.
C) are not traded on organized exchanges.
D)are not marked to market daily.

Question 49

The purpose of a margin account for a futures contract is to:

A) guarantee a minimum margin of profit for the contract holder.
B) allow futures traders to have more than one contract simultaneously.
C) provide a cushion for the exchange against defaults on the contract.
D)hold interest payments until expiration.

Question 50

A hedger buys a futures contract that obligates the owner to take delivery of 5,000 bushels of wheat at a price of $6.80 per bushel. At expiration the spot price of wheat is $6.68 per bushel. The hedger has:

A) saved $0.12 per bushel through hedging.
B) gained peace of mind at a price of $0.12 per bushel.
C) the opportunity to avoid taking delivery since the price declined.
D)locked in an effective price of $6.68 per bushel.

Question 51

The effect of marking a futures contract to market is similar to:

A) requiring daily payments from the contract buyer.
B) requiring daily payments from the contract seller.
C) closing the current position and opening a new position daily.
D)imposing a daily fee on both buyers and sellers.

Question 52

A farmer stores his fall harvest of corn and sells corn futures for March delivery at $7.50 per bushel. In March the spot price of corn is $7.20 per bushel. Which of the following is correct?

A) The farmer is obligated to deliver corn to the futures buyer at $7.20.
B) The farmer has locked in an effective price of $7.50 per bushel.
C) The farmer would have been better off without the futures contract.
D)The farmer will receive $7.35 per bushel which is the average of the spot and futures prices.

Question 53

What must happen to prices over the course of a contract for the seller of a futures contract to maximize the benefits of the hedge?

A) Prices must decrease.
B) Prices must increase.
C) Prices must remain constant.
D)The seller will profit on the hedge regardless of the direction of price movements.

Question 54

The process of marking a futures contract to market means that:

A) the profitability of the contract is locked in from the onset of the contract.
B) the amount of commodity to be delivered changes as prices change.
C) contracts are closed out as soon as they become unprofitable.
D)profits or losses are posted to the contract daily.

Question 55

A futures contract seller is obligated to deliver 5,000 bushels of soybeans for $12.00 per bushel at expiration. If soybean futures close at $12.10 the next day, the seller:

A) has a profit of $500 thus far on the contract.
B) has a loss of $500 thus far on the contract.
C) has no profit or loss, but is still obligated to deliver 5,000 bushels at $12.00.
D)will receive a check for $500 from the buyer of the contract.

Question 56

A hedger buys a futures contract that obligates the owner to take delivery of 5,000 bushels of wheat at a price of $6.75 per bushel. At expiration the spot price of wheat is $6.80 per bushel. The hedger has:

A) saved $0.05 per bushel through hedging.
B) gained peace of mind at a price of $0.05 per bushel.
C) the opportunity to avoid taking delivery since the price increased.
D)locked in an effective price of $6.80 per bushel.

Question 57

A soybean oil contract calls for delivery of 60,000 pounds. What happens to the seller of a soybean futures contract at 41 cents per pound if the futures price closes the next day at 42 cents per pound?

A) The contract is marked to market with a $600 loss.
B) The contract is marked to market with a $600 gain.
C) Futures contracts are voided if the price increases prior to expiration.
D)Nothing happens until the expiration of the contract.

Question 58

The customary delivery procedure at the expiration of a commodity futures contract is:

A) delivering the commodity to the futures buyer.
B) delivering the commodity to the futures exchange.
C) offsetting the initial futures position and settling in cash.
D)adding the profit or loss to your margin account and continuing to trade.

Question 59

If the market for corn futures has more prospective sellers than buyers, then one would expect:

A) the price of corn futures to decrease.
B) the price of corn futures to increase.
C) some traders to change from seller to buyer.
D)the market to cease operations until demand is rebalanced.

Question 60

Which one of the following is a major reason for firms to engage in currency swaps?

A) They will be required to repay only the interest.
B) They can obtain more favorable borrowing terms in a different currency.
C) The debt will not show on their balance sheets.
D)Borrowing in a foreign currency offers lucrative tax breaks.

Question 61

Managers are willing to pay a price to hedge because:

A) they receive increased profits in return.
B) the returns on derivative instruments are not taxed.
C) they value the reduction in uncertainty.
D)it permits the managers to receive higher cash bonuses.

Question 62

Why are most futures contracts not settled through delivery of the product?

A) Most contracts are settled through the margin account.
B) Most contracts expire with neither party having an obligation to the other party.
C) Most participants cancel their futures contracts through purchase of an option contract.
D)It is easier and cheaper to settle in cash or by offset.

Question 63

Financial futures are available to protect against all of the following except:

A) interest rate risk.
B) level of equity prices.
C) currency swap risk.
D)exchange rate risk.

Question 64

In general, when deciding whether a market participant needs to buy or sell futures contracts in order to hedge, the rule could be:

A) buy futures if you have the underlying asset and sell futures if you need the underlying asset.
B) sell futures if you have the underlying asset and buy futures if you need the underlying asset.
C) buy futures if you want to speculate, sell futures if you want to hedge.
D)buy futures if you are willing to have unlimited risk, sell futures if you want capped risk.

Question 65

How does a soybean farmer lock in a price of $14.40 per bushel when the cash price at harvest is only $14?

A) Profit in futures market to offset loss in cash market by selling futures contracts at $14.40/bushel.
B) Break even in both markets by buying a futures contract at $14.40/bushel.
C) Profit in cash market to offset loss in futures market by buying futures contract at $14.40/bushel.
D)Break even in both markets by selling a futures contract at $14.40/bushel.

Question 66

Which one of the following statements is correct for an interest rate swap?

A) There is an exchange of loan contracts between counterparties.
B) There is no exchange of principal between counterparties.
C) There is an exchange of currencies between counterparties.
D)There is no exchange of cash between counterparties.

Question 67

Because most hedging acts to reduce risk, managers should expect that hedging will:

A) increase profits.
B) decrease profits.
C) increase the firm's stock price.
D)stabilize the firm's dividend payout.

Question 68

Manufacturers who are concerned about volatile commodity prices often use option contracts to alter their risks. What is the worst-case scenario for a seller of put options on corn with a strike price of $4.75 per bushel?

A) If corn prices drop below $4.75 the option premium will be lost.
B) If corn prices rise above $4.75 the option premium will be lost.
C) Losses can be large if prices drop sufficiently.
D)Losses can be unlimited if prices rise sufficiently.

Question 69

When two borrowers engage in a currency swap, they agree to:

A) a one-time currency exchange equal to the principal amount borrowed.
B) make payments on each other's borrowings in a different currency.
C) pay to each other any depreciation or appreciation of the currency.
D)exchange fixed-rate interest payments for variable-rate interest payments.

Question 70

In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for:

A) fixed-rate payments in another currency.
B) variable-rate payments in another currency.
C) fixed-rate payments in the same currency.
D)variable-rate payments in the same currency.

Question 71

As time draws closer to contract expiration, futures contract prices can be expected to:

A) increase as the demand for delivery intensifies.
B) decrease as speculators resolve the uncertainty of prices.
C) move similarly to broad-based market indices, such as the S&P 500.
D)converge upon the spot price.

Question 72

A gasoline distributor buys a gasoline futures contract that requires acceptance of 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97?

A) A loss of $1,260 is posted to the account.
B) A gain of $1,260 is posted to the account.
C) A loss of $12,600 is posted to the account.
D)A gain of $12,600 is posted to the account.

Question 73

One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer:

A) pays a much higher premium than option buyers.
B) has an obligation to purchase, not a choice.
C) can lose no more than the initial premium.
D)has increased rather than reduced risk.

Question 74

If managers are rational, they will hedge only when they perceive that:

A) prices are headed in an adverse direction.
B) derivative instruments are priced lower than actual value.
C) risk reduction is preferable to higher potential profits.
D)they can increase their profitability by doing so.

Question 75

The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration?

A) A loss of $400 is posted to the account.
B) A gain of $400 is posted to the account.
C) A loss of $1,200 is posted to the account.
D)A gain of $1,200 is posted to the account.

Question 76

ABC Corp. entered into a currency swap with its bank, providing that ABC borrows $5 million at 10% and swaps for a 12% yen loan. The spot exchange rate is ¥105/$. If interest only is to be repaid on an annual basis, how much does ABC pay annually to the bank?

A) ¥1.26 million
B) ¥5.71 million
C) ¥52.50 million
D)¥63.00 million

Question 77

The typical sequence of cash flows in a futures contract is:

A) purchase price plus a margin account up-front, differences are settled at expiration.
B) margin account up-front, differences are posted daily and settled in cash if margin drops too low.
C) margin account up-front, all differences settled at expiration.
D)all funds are paid at expiration of the contract.

Question 78

The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper?

A) The price closed down $0.02 per pound.
B) The price closed up $0.02 per pound.
C) The price closed down $0.20 per pound.
D)The price closed up $0.20 per pound.

Question 79

Producers who hedge through the purchase of put options must remember that they may be:

A) reducing their profits compared to not hedging.
B) obligated to sell their product at a lower than market price.
C) increasing their overall risk.
D)facing unlimited price risk.

Question 80

Hershey's Chocolate is concerned about cocoa prices prior to building inventory for Halloween sales. Analysts project that the price per ton could vary from $2,900 to $3,100. A September call option can be purchased with a $2,950 strike price for a premium of $145. What is Hershey's worst-case scenario if it purchases these options?

A) Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950.
B) Cocoa prices will decline to $2,850 and Hershey will have to pay an extra $100 per ton.
C) Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the strike price plus the option premium.
D)Cocoa prices will fall below $2,950 and Hershey will lose $145 per option contract.