Question 1

A corporation plans to sell commercial paper one month from now. Buying put options on Treasury bill futures or Eurodollar CD futures lets the corporation ________.

Accepted Answer

The answer of A corporation plans to sell commercial paper...

Question 2

Interest rate options or options on interest rate futures can be used by investors and issuers to speculate on adverse interest rate movements but still benefit from a favorable interest rate movement.

Accepted Answer

The answer of Interest rate options or options on interest...

Question 3

A money manager can use both stock index futures and interest rate futures to more efficiently allocate funds between the stock market and the bond market.

Accepted Answer

By using stock index futures, the money manager can gain exposure to the stock market without having to purchase individual stocks. Similarly, by using interest rate futures, they can gain exposure to the bond market without having to purchase individual bonds. This allows for a more efficient allocation of funds between the two markets.

Question 4

Market participants can obtain downside protection using options at a cost equal to the option price, but preserve upside potential (reduced by the option price).

Accepted Answer

This statement is true. Options can be used to provide downside protection by setting a floor for how much an investor can lose, but also allow for the possibility of gains if the market moves in the investor's favor. The cost of the option is the premium paid for the contract, which reduces the overall potential profit but ensures a certain level of protection from losses.

Question 5

The difference between the cash price and the futures price is called the ________.

Accepted Answer

The difference between the cash price and the futures price is known as the basis. It reflects the supply and demand conditions of a particular commodity in a specific location. The basis can be positive or negative, and it's essential to understand when trading futures contracts.

Question 6

A protective put buying strategy can be used to reduce the risk exposure of a stock portfolio to a decline in stock prices, guaranteeing a maximum price equal to the strike price plus the cost of buying the put option.

Accepted Answer

A protective put strategy does indeed reduce the risk exposure of a stock portfolio to a decline in stock prices, but it guarantees a minimum selling price equal to the strike price minus the cost of buying the put option, not a maximum price.

Question 7

Investors can use stock index futures to speculate on stock prices, control a portfolio's price risk exposure, hedge against adverse stock price movements, construct indexed portfolios, engage in index arbitrage, and create a synthetic put option.

Accepted Answer

Stock index futures can be used for all the purposes mentioned above, making the statement true.

Question 8

Because futures are highly leveraged and transactions costs are less than in the cash market, market participants can alter their risk exposure to a market (stock or bond) less efficiently in the futures market.

Accepted Answer

Futures allow market participants to alter their risk exposure more efficiently due to their leverage and lower transaction costs compared to the cash market.

Question 9

By taking an appropriate position in a suitable stock index option, an institutional investor can create a protective call for a diversified portfolio.

Accepted Answer

A protective call strategy involves buying a call option to hedge against potential losses in a stock position, but the correct term for creating a hedge for a diversified portfolio using options is a "protective put," where the investor buys put options to protect against potential downside.

Question 10

In regards to hedging, which of the below statements is FALSE?

Accepted Answer

The statement "When the profit and loss are equal, the hedge is called an equal hedge" is false. A hedge is considered to be "perfect" or "effective" when the profit and loss from the hedge equals the change in the value of the cash position. A hedge is not considered to be "equal" when the profit and loss are equal.

Question 11

Buying a futures contract decreases a market participant's exposure to a market; selling a futures contract decreases a market participant's exposure to a market.

Accepted Answer

Buying a futures contract increases a market participant's exposure to a market, while selling a futures contract increases their exposure.

Question 12

Market participants can use interest rate futures to control interest rate movements, speculate on a portfolio's risk exposure to interest rate changes, hedge against adverse interest rate movements, and enhance returns when futures are mispriced.

Accepted Answer

The answer of Market participants can use interest rate futures...

Question 13

The major function of futures markets is to transfer price risk from ________.

Accepted Answer

The major function of futures markets is to transfer price risk from hedgers to speculators. Hedgers use futures contracts to protect themselves from potential price fluctuations in the underlying asset. Speculators, on the other hand, take on risk in the hopes of making a profit by correctly predicting the direction of price movements. Thus, futures markets allow hedgers to transfer their price risk to speculators who are willing to take it on in exchange for the potential for profit.

Question 14

The purchase of a call option can be used to guarantee that the maximum price that will be paid in the future is the strike price plus the option price.

Accepted Answer

When a call option is purchased, it gives the buyer the right, but not the obligation, to purchase the underlying asset at the strike price. Therefore, buying a call option can help guarantee that the maximum price paid for the asset in the future is the strike price plus the cost of the option. If the market price of the underlying asset rises above the strike price, the buyer of the call can exercise the option and purchase the asset at the lower strike price plus the cost of the option.

Question 15

The effectiveness of a cross hedge will be determined by ________.

Accepted Answer

The effectiveness of a cross hedge will depend on the relationship between the cash price of the underlying instrument and its futures price at the time when a hedge is placed and the time when it is lifted. This is because a cross hedge involves hedging with a futures contract that is not directly linked to the underlying asset being hedged. Therefore, changes in the basis (the difference between cash and futures prices) can impact the effectiveness of the hedge. A good cross hedge should have a strong correlation between the cash and futures prices, reducing the impact of basis changes. Option A and C are incorrect because they do not accurately describe the factors that determine cross-hedge effectiveness. Option D is incorrect because the market value of the portfolio is not directly relevant to the effectiveness of the hedge.

Question 16

When a futures contract is used to hedge a position where either the portfolio or the individual financial instrument is not identical to the instrument underlying the futures, it is called ________.

Accepted Answer

Cross hedging involves using a futures contract to hedge a position where the underlying instrument is not identical to what is being hedged. It is commonly used when a perfect hedge is not possible due to the unavailability of the appropriate instrument.

Question 17

A corporation plans to issue long-term bonds two months from now. To protect itself against a rise in interest rates, the corporation can buy put options. If interest rates rise, the interest cost of the bonds issued two months from now will be ________, but the put option will have ________ in value.

Accepted Answer

To protect against a rise in interest rates, buying put options on interest rates would mean that if interest rates rise, the cost of issuing bonds (interest cost) would indeed be higher. However, the value of the put options would increase because they would become more valuable as they allow the holder to sell at the now higher interest rate.

Question 18

A long hedge is used to protect against a decline in the cash price of a financial instrument or portfolio.

Accepted Answer

A long hedge is used to protect against an increase in the price of a financial instrument or portfolio, typically by purchasing futures contracts to lock in prices.

Question 19

A thrift or commercial bank wants to make sure that the cost of its funds will not exceed a certain level. This can be done by ________.

Accepted Answer

Buying call options on Eurodollar CD futures allows a bank to lock in a maximum purchase price for the CDs, thus ensuring the cost of its funds does not exceed a certain level.

Question 20

A short hedge is undertaken to protect against an increase in the price of a financial instrument or portfolio to be purchased in the cash market at some future time.

Accepted Answer

A short hedge is undertaken to protect against a decrease in the price of a financial instrument or portfolio that an investor currently holds or plans to sell in the future, not against an increase in price for future purchases.

Quiz 29: The Applications of Futures and Options Contracts