Question 1

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one-year loan is 7 percent and a two-year loan is 8 percent, it should quote 7.5 percent, which is the average of the two rates.

Accepted Answer

The bank should quote a rate based on the expectations of future interest rates, not just the average of current rates. If the bank expects interest rates to increase in the next year, it may quote a higher rate than 7.5%. If it expects rates to decrease, it may quote a lower rate.

Question 2

The hedge ratio or delta measures the sensitivity of the value of one asset relative to the value of another asset.

Accepted Answer

The statement is true. The hedge ratio or delta is commonly used in options trading to measure how much the value of an option will change in relation to changes in the underlying asset's price. It can also be used in other forms of hedging to determine how much of one asset needs to be held in order to offset the risk of another asset.

Question 3

Disadvantages faced by insurance companies in bearing risk include administrative costs, adverse selection, and moral hazard.

Accepted Answer

Administrative costs refer to the expenses incurred by insurance companies in managing and processing claims. Adverse selection occurs when a higher proportion of risky individuals are allowed to purchase insurance policies, increasing the likelihood of claims and losses for the company. Moral hazard refers to the tendency of insured individuals to take greater risks or engage in more careless behavior since they know they are protected by insurance. These factors can increase the overall risk and cost for insurance companies.

Question 4

What are the four basic types of contracts or instruments used in financial risk management?

Accepted Answer

The answer of What are the four basic types of...

Question 5

"Mark to market" means that, each day, any profits or losses are calculated and the trader's margin account is adjusted accordingly.

Accepted Answer

Mark to market is the practice of calculating profits and losses each day and adjusting the trader's margin account accordingly.

Question 6

Briefly explain the term derivative.

Accepted Answer

The answer of Briefly explain the term derivative....

Question 7

For financial futures, Futures price = (spot price)/(1 + r_f - y)^t.

Accepted Answer

This is the correct formula for calculating futures price, where spot price, interest rate, dividend yield, and time to expiration are taken into account.

Question 8

For commodity futures: Net convenience yield = (convenience yield − storage costs).

Accepted Answer

This formula is correct for calculating the net convenience yield in commodity futures. The convenience yield represents the benefits of holding a physical commodity, such as the ability to provide immediate delivery to customers, while storage costs represent the costs associated with holding the physical commodity in storage. By subtracting the storage costs from the convenience yield, we arrive at the net benefit of holding the commodity.

Question 9

As a commodity futures contract nears expiration, the futures price converges to the spot market price for that commodity.

Accepted Answer

This is known as the "convergence" of futures and spot prices, where the futures price eventually equals the spot price at the time of expiration. This is due to traders arbitraging between the two markets, buying low in the futures market and selling high in the spot market.

Question 10

Futures contracts are usually marked to market.

Accepted Answer

Futures contracts are typically marked to market, which means that the gains or losses on the contract are settled on a daily basis. This practice ensures that any losses or gains are reflected in the investor's account in a timely manner.

Question 11

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one-year loan is 7 percent and a two-year loan is 8 percent, it should quote 9 percent.

Accepted Answer

The forward rate for a one-year loan one year from today is the current two-year rate, which is 8 percent.

Question 12

Four investors enter into long sugar contracts. Three are speculators and one is hedging. Which of the following is hedging?
A)Wheat farmer
B)Cereal company
C)Mutual fund
D)None of these answers are correct.

Accepted Answer

A cereal company might enter into a long sugar contract to hedge against the risk of rising sugar prices, which would affect their production costs.

Question 13

Are companies that purchase or sell derivative contracts necessarily speculating?

Accepted Answer

The answer of Are companies that purchase or sell derivative...

Question 14

The convenience yield on a commodity futures contract is the implicit extra value created by holding the actual commodity rather than a financial claim on it.

Accepted Answer

The convenience yield refers to the additional benefits or advantages received from holding physical possession of a commodity beyond the financial benefits gained from holding a futures contract. It is a significant concept in commodities futures trading as it helps in understanding the pricing behavior of the futures contract.

Question 15

For commodity futures, (Futures price)× (1 + r_f)^t = spot price − net convenience yield.

Accepted Answer

The correct relationship for commodity futures pricing, considering interest rates and convenience yield, is: Futures price = (Spot price - Net convenience yield) × (1 + r)^t, where r is the risk-free interest rate and t is the time to maturity. The formula provided in the question is not a standard or recognized formula for futures pricing.

Question 16

Derivative instruments are financial contracts whose value depends on the value of another asset.

Accepted Answer

Derivative instruments such as options, futures, and swaps derive their value from assets such as stocks, commodities, and currencies.

Question 17

In bearing risk, what disadvantages do insurance companies face?

Accepted Answer

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Question 18

Most of the world's largest companies use derivatives to manage risk.

Accepted Answer

Derivatives are commonly used by large companies for risk management purposes. These financial instruments can help companies hedge against fluctuations in interest rates, exchange rates, commodity prices, and other market factors. Many of the world's biggest corporations, from Apple to ExxonMobil, use derivatives as part of their risk management strategies.

Question 19

What investment would be a hedge for a corn farmer?
A)Long corn put option
B)Long corn call option
C)Long corn futures
D)None of these answers are correct.

Accepted Answer

A long corn put option would be a hedge for a corn farmer because it gives them the right to sell corn at a specific price, which can help protect them against price drops. This would help offset any potential losses in the event that the price of corn decreases.

Question 20

A company that wishes to lock in an interest rate on future borrowing can either enter into a forward rate agreement (FRA)or it can borrow long-term funds and lend short-term.

Accepted Answer

A company can enter into a forward rate agreement to lock in an interest rate on future borrowing, or they can borrow long-term funds and lend short-term, but they cannot do both simultaneously.

Quiz 26: Managing Risk