Question 1

Organized trading is much more common in forward contracts than in futures contracts.

Accepted Answer

Futures contracts are standardized and traded on organized exchanges, making them more common in organized trading environments than forward contracts, which are private agreements between two parties and not traded on exchanges.

Question 2

Commodity prices, inflation, exchange rates and interest rates have become more volatile over the past thirty years.

Accepted Answer

Advancements in technology, globalization, and policy changes have increased the interconnectedness of markets, leading to more rapid dissemination of information and quicker reactions from investors and traders. This has contributed to increased volatility in commodity prices, inflation, exchange rates, and interest rates over the past thirty years.

Question 3

Your company uses wheat in the production of a cereal product. To lock in the acquisition cost of your wheat, you could either sell a futures contract on wheat, or sell a futures call option on wheat.

Accepted Answer

To lock in the acquisition cost of wheat, a company should buy a futures contract or buy a futures call option on wheat, not sell them. Selling would be a strategy for producers or those looking to hedge against the price of wheat they're selling, not securing a purchase price.

Question 4

The main difference between a forward contract and a futures contract is that the contract price changes hands at the initiation of the contract with forward contracts but at maturity with futures.

Accepted Answer

The main difference is that forward contracts are private, over-the-counter agreements between two parties, and their terms are customizable, including when the contract price changes hands, which is typically at maturity, not at initiation. Futures contracts are standardized and traded on exchanges, with the contract price (margin requirements) potentially changing hands daily due to market variations, but the full contract value typically exchanges at maturity.

Question 5

For forward contracts, the payoff profile for the seller of a forward contract is a downward sloping linear function.

Accepted Answer

The payoff profile for the seller of a forward contract is indeed a downward sloping linear function because the seller benefits from a decrease in the asset's price below the agreed-upon price and incurs losses as the price increases above the agreed-upon price.

Question 6

A key difference between an option contract and a forward contract is that the option price is determined at settlement while the forward price is determined when the contract is initiated.

Accepted Answer

In an option contract, the option price, or premium, is determined when the contract is initiated, not at settlement. Conversely, the forward price is also determined when the contract is initiated, setting the price at which the asset will be bought or sold in the future.

Question 7

Commodity prices, inflation, exchange rates and interest rates have become less volatile over the past thirty years.

Accepted Answer

While there have been periods of relative stability, overall, commodity prices, inflation, exchange rates, and interest rates have experienced significant volatility over the past thirty years due to various global economic crises, policy changes, and market dynamics.

Question 8

Firms with high financial distress costs or those with constrained access to capital markets most frequently use derivatives.

Accepted Answer

The answer of Firms with high financial distress costs or...

Question 9

For forward contracts, if a buyer of a contract wins by $100 then the seller incurred a $100 loss.

Accepted Answer

In a forward contract, the gain of one party is exactly offset by the loss of the other party, making it a zero-sum game.

Question 10

Interest rate forward contracts are publicly traded.

Accepted Answer

Interest rate forward contracts are typically over-the-counter (OTC) derivatives, meaning they are privately negotiated and not traded on public exchanges.

Question 11

Firms with low financial distress costs or those with easy access to capital markets most frequently use derivatives.

Accepted Answer

Firms with low financial distress costs or easy access to capital markets often use derivatives to hedge risks, manage financial exposure, and optimize their capital structure, as they have the resources and expertise to effectively utilize these financial instruments.

Question 12

A financially sound firm can become financially distressed as the result of its short-run exposure to financial risk.

Accepted Answer

A financially sound firm can become financially distressed if it is exposed to significant financial risk in the short run, such as sudden changes in interest rates, currency fluctuations, or unexpected financial obligations, which can impact its liquidity and ability to meet short-term obligations.

Question 13

The prices of goods and services have remained relatively stable over the last three decades, but the year-to-year rate of change in those prices has increased dramatically.

Accepted Answer

While there have been periods of relative stability in the prices of goods and services over the last three decades, the statement that the year-to-year rate of change in those prices has increased dramatically is not accurate. Inflation rates, which measure the rate of change in prices, have fluctuated and in many economies have been targeted to remain within certain bounds by central banks, rather than showing a dramatic increase in variability.

Question 14

Gateway Reproductions uses sheet steel to manufacture reproduction fenders for classic automobiles. The firm's risk profile with regard to sheet steel will be downward-sloping.

Accepted Answer

A downward-sloping risk profile indicates that as the price of sheet steel decreases, the firm's risk decreases. This is because lower input costs can lead to higher profit margins, reducing financial risk.

Question 15

Interest rate volatility creates a need for financial engineering.

Accepted Answer

Interest rate volatility can lead to uncertainty in financial markets, prompting the development of financial instruments and strategies (financial engineering) to manage or hedge against the risks associated with fluctuating interest rates.

Question 16

It is easier to hedge long-term financial risk than to hedge short-term financial risk.

Accepted Answer

Hedging long-term financial risk is generally more challenging because it involves greater uncertainty and fewer available instruments to effectively manage the risk over an extended period. Short-term risks can be more accurately predicted and managed with a wider range of financial products.

Question 17

The volatility of Canadian short-term interest rates increased after March 1980 due to a change in the way the Bank of Canada manages interest rates.

Accepted Answer

After March 1980, the Bank of Canada shifted its focus towards targeting the money supply rather than directly setting interest rates, which led to increased volatility in short-term interest rates as market forces played a larger role in determining them.

Question 18

Hedging done at a divisional level can increase the overall financial risk of a firm.

Accepted Answer

Hedging at a divisional level can lead to situations where risk management strategies counteract each other across different divisions, potentially increasing the overall financial risk of the firm due to lack of coordination and visibility at the corporate level.

Question 19

The main difference between a futures contract and a forward contract is that with the former, buyers and sellers realize gains or losses on the settlement date, while the latter requires that gains or losses are realized daily.

Accepted Answer

The main difference is that futures contracts are standardized and traded on an exchange, which requires daily settlement of gains and losses (marking to market), while forward contracts are private agreements between two parties and the gains or losses are realized at the settlement date, not daily.

Question 20

The risk of default is larger with futures contracts than with forward contracts largely because the value of the futures contract is marked-to-market daily, resulting in a higher chance that one of the individuals will be unable to make the required deposit.

Accepted Answer

The risk of default is generally lower with futures contracts than with forward contracts because futures are marked-to-market daily and traded on an exchange with a clearinghouse that guarantees the contract, reducing the default risk. Forward contracts, on the other hand, are private agreements with potentially higher default risk due to the lack of a central clearinghouse and daily settlement.

Quiz 24: Enterprise Risk Management