Question 1

Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can lead only to losses.

Accepted Answer

This statement is true. Speculative risks involve a chance of gain or loss, while pure risks only have the possibility of loss.

Question 2

An option is a definite agreement leading to a firm completion of the transaction.

Accepted Answer

An option grants the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date, without committing them to complete the transaction.

Question 3

Which of the following statements best describes contracts?

Accepted Answer

This statement accurately describes futures contracts, which trade on organized exchanges and are marked to market daily to reflect changes in their underlying assets. Statement A is incorrect because forward contracts are not default free, as there is always a risk of one party defaulting on their obligation to deliver or pay for the underlying asset. Statement C is also incorrect because both forward and futures contracts can involve physical delivery of goods, though many futures contracts are settled in cash without physical delivery.

Question 4

Which of the following statements best describes interest rate and reinvestment rate risk?

Accepted Answer

Interest rate price risk refers to the potential loss in value of a fixed-rate security when interest rates rise, while reinvestment rate risk is the risk that the investor will be unable to reinvest the cash flows from the security at the same rate, resulting in lower than expected returns. It is not possible to eliminate either type of risk completely, but strategies such as diversification and managing the duration of the portfolio can help to mitigate them. Zero coupon bonds do not eliminate interest rate price risk, as they are subject to changes in market interest rates. Similarly, variable or floating rate bonds do not eliminate reinvestment rate risk, as the investor remains exposed to changes in interest rates at the time of reinvestment.

Question 5

Suppose the standard size of a copper futures contract is 25,000 pounds each. At initiation of a futures contract, the futures price is $22.50 per pound. At expiration of the futures contract, the copper price is $19.50 per pound. Which of the following is true?

Accepted Answer

Since the futures price at initiation was $22.50 and the price at expiration was $19.50, the price decreased by $3 per pound. In a futures contract, the short profits when the price of the underlying asset decreases, so the short (seller) profits by $3 per pound.

Question 6

A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?

Accepted Answer

The answer of A commercial bank recognizes that its net...

Question 7

A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT correct?

Accepted Answer

The statement "A problem with swaps is the short maturities, which has prevented the development of a secondary market" is not correct. Swaps typically have longer maturities than other financial instruments and a robust secondary market has developed for many types of swaps.

Question 8

Which of the following are NOT ways risk management can be used to increase the value of a firm?

Accepted Answer

Risk management strategies are primarily focused on the financial and operational aspects of a firm to protect its value and ensure sustainability. While they can help maintain optimal capital budgets, reduce financial distress costs, and minimize taxes, they are not designed to manage personal compensation strategies such as deferring managers' bonuses to postpone tax payments. This choice does not align with the primary objectives of corporate risk management.

Question 9

Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

Accepted Answer

A swap can potentially reduce actual net interest expenses by allowing a firm to take advantage of lower floating interest rates. However, there may be other costs associated with implementing the swap, such as transaction fees or credit risk, which could offset any savings from the swap.

Question 10

Suppose the June 2008, 10-year, $100,000 Government of Canada bond futures contract has a quoted price of 118.72. The notional amount involved is $27,234,486,720. What is the open interest?

Accepted Answer

The answer of Suppose the June 2008, 10-year, $100,000 Government...

Question 11

Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B?

Accepted Answer

A's original cost is LIBOR + 1%. After the swap, A pays 7.95% fixed to B and receives LIBOR from B, effectively paying 7.95% fixed. B's original cost is 9.4% fixed. After the swap, B pays LIBOR to A and receives 7.95% fixed from A, effectively paying 9.4% - 7.95% = 1.45% over LIBOR, or LIBOR + 1.45%.

Question 12

The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

Accepted Answer

The terms "long" and "short" in hedges refer to the position taken in the futures market, not the maturity of the hedging instrument. A long hedge involves buying futures contracts to protect against price increases, while a short hedge involves selling futures contracts to protect against price decreases.

Question 13

One objective of risk management can be to reduce the volatility of a firm's cash flows.

Accepted Answer

One of the primary aims of risk management is to minimize the adverse effects of uncertainty on a company's operations and profitability. This includes reducing the variability of the company's cash flows so that it can better plan for investments, dividends, and debt service obligations.

Question 14

Suppose the quoted price for a June 2008 10-year CGB futures contract has changed from 118.72 to 118.77. What is the corresponding change in value in this futures contract?

Accepted Answer

Each point in a CGB futures contract is worth CNY 100. Therefore, the change in value is 0.05 points, or CNY 5.0, which is equivalent to $50 (assuming an exchange rate of CNY 6.0 per USD).

Quiz 21: Derivatives and Risk Management