Deck 25: Financial Risk Management With Derivatives

Question 1

A swap is an arrangement for two counterparties to:

A)exchange cash flows over time.
B)permit fluctuation in interest rates.
C)to help exchange markets clear.
D)to equate the duration of liabilities with the duration of assets.
E)None of the above.

Answer 1

exchange cash flows over time.

Question 2

A farmer with wheat in the fields and who uses the futures market to protect a profit is an example of:

A)A long hedge.
B)A short hedge.
C)Selling futures to guard against a potential loss.
D)Both A and C.
E)Both B and C.

Answer 2

Both B and C.

Question 3

The main difference between a forward contract and a cash transaction is:

A)only the cash transaction creates an obligation to perform.
B)a forward is performed at a later date while the cash transaction is performed immediately.
C)only one involves a deliverable instrument.
D)forwards contracts should always be in writing.
E)None of the above.

Answer 3

a forward is performed at a later date while the cash transaction is performed immediately.

Question 4

Derivatives can be used to either hedge or speculate.These actions:

A)increase risk in both cases.
B)decrease risk in both cases.
C)spread or minimize risk in both cases.
D)offsets risk by hedging and increase risk by speculating.
E)offset risks by speculating and increase risk by hedging.

Question 5

If rates in the market fall between now and one month from now, the mortgage banker:

A)loses as the mortgages are sold at a discount.
B)gains as the mortgages are sold at a discount.
C)loses as the mortgages are sold at a premium.
D)gains as the mortgages are sold at a premium.
E)neither gains nor loses.

Question 6

You hold a forward contract to take delivery of Treasury bonds in 9 months.If the entire term structure of interest rates shifts down over the 9-month period, the value of the forward contract will
Have _____ on the date of delivery.

A)risen
B)fallen
C)not changed
D)either risen or fallen, depending on the maturity of the T-bond
E)collapsed

Question 7

Which of the following terms is not part of a forward contract?

A)Making delivery
B)Taking delivery
C)Delivery instrument
D)Cash transaction
E)None of the above.

Question 8

LIBOR stands for:

A)Lausanne Interest Basis Offered Rate.
B)London International Offered Rate.
C)London Interbank Offered Rate.
D)London Interagency Offered Rate.
E)None of the above.

Question 9

A forward contract is described by:

A)agreeing today to buy a product at a later date at a price to be set in the future.
B)agreeing today to buy a product today at its current price.
C)agreeing today to buy a product at a later date at a price set today.
D)agreeing today to buy a product if and only if its price rises above the exercise price today
At its current price.
E)None of the above.

Question 10

Duration is a measure of the:

A)yield to maturity of a bond.
B)coupon yield of a bond.
C)price of a bond.
D)effective maturity of a bond.
E)All of the above.

Question 11

The buyer of a forward contract:

A)Will be taking delivery of the good(s) today at today's price.
B)Will be making delivery of the good(s) at a later date at that date's price.
C)Will be making delivery of the good(s) today at today's price.
D)Will be taking delivery of the good(s) at a later date at pre-specified price.
E)Both A or D.

Question 12

Which of the following is true about the use of derivatives?

A)Derivatives usually appear explicitly in the financial statements.
B)Academic surveys account for much of our knowledge of corporate derivatives use.
C)Smaller firms are more likely to use derivatives than large firms.
D)Frequently, firms use derivatives where financial distress costs are low.
E)None of the above are true.

Question 13

Futures contracts contrast with forward contracts by:

A)trading on an organized exchange.
B)marking to the market on a daily basis.
C)allowing the seller to deliver any day over the delivery month.
D)the clearing house who guarantee the transaction to lower the probability of default.
E)All of the above.

Question 14

A futures contract on gold states that buyers and sellers agree to make or take delivery of an ounce of gold for £800 per ounce.The contract expires in 3 months.The current price of gold is £700 per
Ounce.If the price of gold rises and continues to rise every day over the 3 month period, then when
The contract is settled, the buyer will_____and the seller will _____.

A)lose; gain
B)gain; lose
C)gain; break even
D)gain; gain
E)lose; lose

Question 15

A chocolate company which uses the futures market to lock in the price of cocoa to protect a profit is an example of:

A)A long hedge.
B)A short hedge.
C)Purchasing futures to guard against a potential loss.
D)Both A and C.
E)Both B and C.

Question 16

A miller who needs wheat to mill to make flour uses the futures market to protect a profit by:

A)A long hedge to take delivery.
B)A short hedge to deliver.
C)Buying futures to guard against a potential loss.
D)Both A and C.
E)Both B and C.

Question 17

If the producer of a product has entered into a fixed price sale agreement for that output, the producer faces:

A)a nice steady profit because the output price is fixed.
B)an uncertain profit if the input prices are volatile.This risk can be reduced by a short
Hedge.
C)an uncertain profit if the input prices are volatile.This risk can be reduced by a long
Hedge.
D)a modest profit if the input prices are stable.This risk can be reduced by a long hedge.
E)a modest profit if the input prices are stable.This risk can be reduced by a short hedge.

Question 18

Two key features of futures contracts that make them more in demand than forward contracts are:

A)futures are traded on exchanges and must be marked to the market.
B)futures contracts allow flexibility in delivery dates and provide a liquid market for netting
Positions.
C)futures are marked to the market and allow delivery flexibility.
D)futures are traded in liquid markets and are marked to the market.
E)None of the above.

Question 19

A potential disadvantage of forward contracts versus futures contracts is:

A)The extra liquidity required to cover the potential outflows that occur prior to delivery
And caused by marking to market.
B)The incentive for a particular party to default.
C)That the buyers and sellers don't know each other and never meet.
D)That the delivery instrument doesn't exist to cover the default risk.
E)Both A and C.

Question 20

A derivative is a financial instrument whose value is determined by:

A)regulatory body such as the FTC.
B)a primitive or underlying asset.
C)hedging a risk.
D)hedging a speculation.
E)None of the above.

Question 21

A financial institution can hedge its interest rate risk by:

A)matching the duration of its assets to the duration of its liabilities.
B)setting the duration of its assets equal to half that of the duration of its liabilities.
C)match the duration of its assets weighted by the market value of its assets with the
Duration of its liabilities weighted by the market value of its liabilities.
D)setting the duration of its assets weighted by the market value of its assets to one half that
Of the duration of the liabilities weighted by the market value of the liabilities.
E)None of the above.

Question 22

In percentage terms, higher coupon bonds experience a _______ price change compared with lower coupon bonds of the same maturity given a change in yield to maturity.

A)greater
B)smaller
C)similar
D)smaller or greater
E)None of the above.

Question 23

An inverse floater and super-inverses are more valuable to a purchaser if:

A)interest rates stay the same.
B)interest rates fall.
C)interest rates rise.
D)if held for a long time.
E)None of the above.

Question 24

Duration of a coupon paying bond is:

A)equal to its number of payments.
B)less than a zero coupon bond.
C)equal to the zero coupon bond.
D)equal to its maturity.
E)None of the above.

Question 25

To protect against interest rate risk, the mortgage banker should:

A)buy futures, as this position will hedge loses if rates rise.
B)sell futures, as this position will hedge losses if rates rise.
C)sell futures, as this position will add to his gains if rates rise.
D)buy futures, as this position will add to his gains if rates rise.
E)None of the above.

Question 26

A bond manager who wishes to hold the bond with the greatest potential volatility would be wise to hold:

A)short-term, high-coupon bonds.
B)long-term, low-coupon bonds.
C)long-term, zero-coupon bonds.
D)short-term, zero-coupon bonds.
E)short-term, low-coupon bonds.

Question 27

Duration of a pure discount bond:

A)is equal to its half-life.
B)is less than a zero coupon bond.
C)is equal to the liabilities hedged.
D)equal to its maturity.
E)None of the above.

Question 28

If a firm purchases a cap at 10% this will:

A)limit the amount of borrowing to 10% of assets.
B)pay the firm 10% on their purchase.
C)pay the holder the LIBOR interest above 10%.
D)pay the holder the LIBOR interest below the 10%.
E)None of the above.

Question 29

Futures market transactions are used to reduce risk.Risk may not be totally offset if:

A)the two instruments have different maturities.
B)payoff schedules of the two instruments are different.
C)the volatility of the two instruments are different.
D)the price movements are not perfectly correlated.
E)All of the above.

Question 30

Hedging in the futures markets can reduce all risk if:

A)price movements in both the cash and futures markets are perfectly correlated.
B)price movements in both the cash and futures markets have zero correlation.
C)price movements in both the cash and futures markets are less than perfectly correlated.
D)the hedge is a short hedge, but not a long hedge.
E)the hedge is a long hedge, but not a short hedge.

Question 31

Interest rate and currency swaps allow one party to exchange a:

A)floating interest rate or currency value for a fixed value over the contract term.
B)fixed interest rate or currency value for a lower fixed value over the contract term.
C)floating interest rate or currency value for a lower floating value over the contract term.
D)fixed interest rate position for a currency position over the contract term.
E)None of the above.

Question 32

A pure discount bond pays:

A)no coupons, therefore its duration equal to its maturity.
B)discounted coupons, therefore its duration is greater than its maturity.
C)level coupons, therefore its duration is equal to its maturity.
D)declining coupons, therefore its duration is less than its maturity.
E)None of the above.

Question 33

A set of bonds all have the same maturity.Which one has the least percentage price changes for given shifts in interest rates:

A)zero coupon bonds.
B)high coupon bonds.
C)low coupon bonds.
D)pure discount bonds.
E)not enough information to determine.

Question 34

When interest rates shift, the price of zero coupon bonds:

A)are more volatile as compared with short-term bonds of the same maturity.
B)are less volatile as compared with short-term bonds of the same maturity.
C)are more volatile as compared with long-term bonds of the same maturity.
D)are less volatile as compared with long-term bonds of the same maturity.
E)Both A and C.

Question 35

A savings and loan has extremely long-term assets that are currently matched against extremely short-term liabilities.For this S&L:

A)Falling interest rates will decrease the value of its equity.
B)Falling interest rates will increase the value of its equity.
C)Rising interest rates will increase the value of its equity.
D)Rising interest rates will decrease the value of its equity.
E)Both B and D.

Question 36

The duration of a 15 year zero coupon bond priced at €182.70 is:

A)2.74 years.
B)15 years.
C)17.74 years.
D)cannot determine without the interest rate.
E)None of the above.

Question 37

If a financial institution has equated the dollar effects of interest rate risk on the assets with the dollar effects on the liabilities, it has engaged in:

A)a long hedge.
B)a short hedge.
C)a protected swap.
D)immunizing interest rate risk.
E)None of the above.

Question 38

Comparing long-term bonds with short-term bonds, long-term bonds are _____ volatile and therefore experience _____ price change than short-term bonds for the same interest rate shift.

A)less; less
B)less; more
C)more; more
D)more; less
E)more; the same

Question 39

A financial institution has equity equal to one-tenth of its assets.If its asset duration is currently equal to its liability duration, then to immunize, the firm needs to:

A)decrease the duration of its assets.
B)increase the duration of its assets.
C)decrease the duration of its liabilities.
D)do nothing, i.e., keep the duration of its liabilities equal to the duration of its assets.
E)None of the above.

Question 40

Exotic derivatives are complicated blends of other derivatives.Some exotics are:

A)Inverse floaters.
B)Cap and floors.
C)Futures.
D)Both A and B.
E)Both B and C.

Question 41

Duration is defined as the weighted average time to maturity of a financial instrument.Explain how this knowledge can help protect against interest rate risk.

Question 42

You have taken a short position in a futures contract on corn at £2.60 per bushel.Over the next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70.You then decide to reverse your position in
The futures market on the fifth day at close.What is the net amount you receive at the end of 5
Days?

A)£0.00
B)£2.60
C)£2.70
D)£2.80
E)Must know the number of contracts.

Question 43

Consider the following two statements: (i) mark-to-the-market provisions protect the seller of a futures contract if the market price of a
Product drops between the contract date and the delivery date.
(ii) mark-to-the-market provisions protect the buyer of a futures contract if the market price of a
Product increases between the contract date and the delivery date.

A)(i) is correct, (ii) is incorrect.
B)(ii) is correct, (i) is incorrect.
C)(i) and (ii) are both correct.
D)(i) and (ii) are both incorrect.
E)(i) and (ii) are both correct only if it is a forward contract.

Question 44

Suppose you agree to purchase one-ounce of gold for £382 any time over the next month.The current price of gold is £380.The spot price of gold then falls to £377 the next day.If the agreement
Is represented by a futures contract marking to market on a daily basis as the price changes, what is
Your cash flow at the end of the business on the next day?

A)£ 0
B)£ 3
C)£ 5
D)£-3
E)£-5

Question 45

You are doing research into speculation.You find that an investor named X as taken an option position Y.You think that in order to know whether position Y is indeed speculative:

A)You need to know how much X has invested in Y.
B)You need to know the total wealth of X.
C)You need to know the underlying positions of X.
D)A and B are correct
E)A and C are correct.

Question 46

Calculate the duration of a 7-year £1,000 zero-coupon bond with a current price of £399.63 and a yield to maturity of 14%.

A)5 years
B)6 years
C)7 years
D)8 years
E)9 years

Question 47

Tiger State Bank

Calculate the duration of Tiger State Bank's assets and liabilities.

Question 48

The duration of a 2 year annual 10% bond that is selling for par is:

A)1.00 years.
B)1.91 years.
C)2.00 years.
D)2.09 years.
E)None of the above.

Question 49

A bank has a $50 million mortgage bond risk position which it hedges in the Treasury bond futures markets at the Chicago Board of Trade.Approximately how many contracts are needed to be held
In the hedge?

A)5
B)50
C)500
D)5,000
E)50,000

Question 50

On March 1, you contract to take delivery of 1 ounce of gold for £415.The agreement is good for any day up to April 1.Throughout March, the price of gold hit a low of £385 and hit a high of £435.The
Price settled on March 31 at £420, and on April 1st you settle your futures agreement at that price.
Your net cash flow is:

A)£-30.
B)£-20.
C)£-15.
D)£ 5.
E)£20.

Question 51

Your friend and fellow student Alex tells you that duration is the cash flow weighted maturity of an asset or liability.Another student, Ben, tells you that it is the effective maturity.

A)Alex is correct, Ben is incorrect.
B)Ben is correct, Alex is incorrect.
C)Alex and Ben are both incorrect.
D)Alex and Ben are both correct.
E)Alex and Ben are only correct if the asset is a zero coupon bond.

Question 52

You have taken a short position in a futures contract on corn at £2.60 per bushel.Over the next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70.Before you can reverse your position in the
Futures market on the fifth day you are notified to accept delivery.What will you receive on delivery
And what is the net amount you receive in total?

A)£2.60; £-0.10
B)£2.60; £0.10
C)£2.60; £2.70
D)£2.70; £-0.10
E)£2.70; £2.60

Question 53

Calculate the duration of a 4-year £1,000 face value bond, which pays 8% coupons annually throughout maturity and has a yield to maturity of 9%.

A)3.29 years
B)3.58 years
C)3.69 years
D)3.89 years
E)4.00 years

Question 54

A mortgage banker had made loan commitments for £10 million in 3 months.How many contracts on Treasury bonds futures must the banker write or buy?

A)Go short 10.
B)Go short 100.
C)Go long 10.
D)Go long 100.
E)None of the above.

Question 55

Tiger State Bank

What new asset duration will immunize the balance sheet?

Question 56

Consider the following two statements: (i) Buying a futures contract to reduce risk close to delivery is called a short hedge.
(ii) The hedging decision is independent of market efficiency.

A)(i) is correct, (ii) is incorrect.
B)(ii) is correct, (i) is incorrect.
C)(i) and (ii) are both correct.
D)(i) and (ii) are both incorrect.
E)(i) and (ii) are both correct only if it is a forward contract.

Question 57

Firm A is paying £750,000 in interest payments a year while Firm B is paying LIBOR plus 75 basis points on £10,000,000 loans.The current LIBOR rate is 6.5%.Firm A and B have agreed to swap
Interest payments.What is the net payment this year?

A)Firm A pays £750,000 to Firm B
B)Firm B pays £725,000 to Firm A
C)Firm B pays £25,000 to Firm A
D)Firm A pays £25,000 to Firm B
E)None of the above.

Question 58

If a firm sells a floor at 6% this will:

A)pay the holder the LIBOR interest below 6%.
B)pay the firm 6% on their purchase.
C)pay the holder the LIBOR interest above 6%.
D)limit the amount of borrowing to 6% of assets.
E)None of the above.

Question 59

If you bought a futures contract for £2.60 per bushel and the contract ended at £2.70 after several days of trading of £2.52, £2.57, £2.62, £2.68, and £2.70.What would the mark to market sequence
Be?

A)-.08, .05, .05, .06, .02
B).08, -.05, -.05, -.06, -.02
C).08, .03, -.02, -.06, -.10
D)-.08, -.03, .02, .06, .10
E).10, .06, .02, -.03, -.08

Question 60

A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent annual coupon rate.The £1,000 face value is returned at maturity.If the effective annual yield for all
Maturities is 7 percent annually, what is the current price of the Treasury note?

A)£960.68
B)£986.69
C)£1,010.35
D)£1,034.40
E)£1,038.99

Question 61

You are hired by SLOMO bank, a small traditional commercial bank.SLOMO gets most of its income from loans to consumers and small businesses, and is largely funded with deposits.Your first job is the assess SLOMO's asset-liability management.You observe that the yield curve becomes steeper What does this mean for SLOMO bank, given its duration gap?

Question 62

You are hired by SLOMO bank, a small traditional commercial bank.SLOMO gets most of its income from loans to consumers and small businesses, and is largely funded with deposits.Your first job is the assess SLOMO's asset-liability management.You decide to assess SLMO's duration gap, by comparing the duration of its assets and its liabilities.What does it look like?

Question 63

When the yield curve shifts, long-term pure discount bonds experience greater price changes than short-term pure discount bonds.Explain why this is the case

Question 64

You are hired by SLOMO bank, a small traditional commercial bank.SLOMO gets most of its income from loans to consumers and small businesses, and is largely funded with deposits.Your first job is the assess SLOMO's asset-liability management.You observe an upward shift in the yield curve. What is the consequence for SLOMO bank, given its duration gap?

Question 65

The futures markets are labeled as pure speculation and even gambling.Why is this an inaccurate portrayal of the markets function?

Question 66

A finance professor tells you that the mark-to-the-market provision on futures contracts makes the future a better hedging instrument than the forward.She also tells you, however, that this is especially the case if the future is perfectly correlated with the underlying asset you are trying to hedge.Explain the professor's reasoning.

Question 67

You can use futures to hedge.However, in doing so, you may not always be able to achieve a perfect hedge.Give three reasons why this may be the case.

Question 68

You are hired by SLOMO bank, a small traditional commercial bank.SLOMO gets most of its income from loans to consumers and small businesses, and is largely funded with deposits.Suddenly, the yield curve becomes inverts.What is the consequence for SLOMO bank, given its duration gap?