Question 1

Managers are willing to pay a price to hedge because:
A) they receive increased profits in return.
B) the returns on derivative instruments are not taxed.
C) they value the reduction in uncertainty.
D)it permits the managers to receive higher cash bonuses.

Accepted Answer

Managers are willing to pay a price to hedge because they value the reduction in uncertainty. Hedging helps managers mitigate potential losses due to market fluctuations, which in turn reduces uncertainty and helps them make better business decisions. The other options (A, B, and D) are not necessarily true for all situations or are not directly related to the benefits of hedging.

Question 2

Why are most futures contracts not settled through delivery of the product?
A) Most contracts are settled through the margin account.
B) Most contracts expire with neither party having an obligation to the other party.
C) Most participants cancel their futures contracts through purchase of an option contract.
D)It is easier and cheaper to settle in cash or by offset.

Accepted Answer

Settlement in cash or by offset is easier and cheaper than delivery of the physical product, which requires storage, transportation, and quality control. Therefore, most futures contracts are settled in this manner.

Question 3

Financial futures are available to protect against all of the following except:
A) interest rate risk.
B) level of equity prices.
C) currency swap risk.
D)exchange rate risk.

Accepted Answer

Financial futures can be used to hedge against interest rate risk, changes in equity prices, and exchange rate risk. However, currency swap risk is not typically hedged using financial futures.

Question 4

In general, when deciding whether a market participant needs to buy or sell futures contracts in order to hedge, the rule could be:
A) buy futures if you have the underlying asset and sell futures if you need the underlying asset.
B) sell futures if you have the underlying asset and buy futures if you need the underlying asset.
C) buy futures if you want to speculate, sell futures if you want to hedge.
D)buy futures if you are willing to have unlimited risk, sell futures if you want capped risk.

Accepted Answer

Hedging is the practice of reducing or eliminating market risk by entering into a position that offsets an existing risk exposure. In the case of futures contracts, buying a futures contract is essentially agreeing to purchase the underlying asset at a future date at a specified price, while selling a futures contract is agreeing to sell the underlying asset at a future date at a specified price. When hedging, market participants should sell futures contracts if they currently hold the underlying asset and want to protect against price declines, as this will offset any losses from a price drop. Conversely, they should buy futures contracts if they don't currently hold the underlying asset but want to protect against price increases, as this will allow them to "lock in" a purchase price. Therefore, option B is the correct answer.

Question 5

How does a soybean farmer lock in a price of $14.40 per bushel when the cash price at harvest is only $14?
A) Profit in futures market to offset loss in cash market by selling futures contracts at $14.40/bushel.
B) Break even in both markets by buying a futures contract at $14.40/bushel.
C) Profit in cash market to offset loss in futures market by buying futures contract at $14.40/bushel.
D)Break even in both markets by selling a futures contract at $14.40/bushel.

Accepted Answer

The soybean farmer can profit in the futures market to offset the loss in the cash market by selling futures contracts at the target price of $14.40 per bushel. This means that the farmer will have effectively locked in a selling price of $14.40 per bushel, regardless of whether the market price at harvest is above or below this level.

Question 6

Which one of the following statements is correct for an interest rate swap?
A) There is an exchange of loan contracts between counterparties.
B) There is no exchange of principal between counterparties.
C) There is an exchange of currencies between counterparties.
D)There is no exchange of cash between counterparties.

Accepted Answer

In an interest rate swap, counterparties agree to exchange interest rate payments on a notional principal amount without exchanging the principal itself. Therefore, there is no exchange of principal between counterparties. Option A is incorrect because there is no exchange of loan contracts. Option C is incorrect because an interest rate swap can be within the same currency. Option D is incorrect because there may be exchanges of cash flows based on the terms of the swap.

Question 7

Because most hedging acts to reduce risk, managers should expect that hedging will:
A) increase profits.
B) decrease profits.
C) increase the firm's stock price.
D)stabilize the firm's dividend payout.

Accepted Answer

Hedging involves taking a position in a financial instrument that will offset potential losses in another position. While this can reduce risk, it can also limit potential profits. Therefore, managers should expect that hedging will decrease profits.

Question 8

Manufacturers who are concerned about volatile commodity prices often use option contracts to alter their risks. What is the worst-case scenario for a seller of put options on corn with a strike price of $4.75 per bushel?
A) If corn prices drop below $4.75 the option premium will be lost.
B) If corn prices rise above $4.75 the option premium will be lost.
C) Losses can be large if prices drop sufficiently.
D)Losses can be unlimited if prices rise sufficiently.

Accepted Answer

For a seller of put options, the worst-case scenario occurs when the price of the underlying asset (in this case, corn) drops significantly below the strike price. This is because the seller of the put option is obligated to buy the asset at the strike price, which could be much higher than the market price, leading to large losses.

Question 9

When two borrowers engage in a currency swap, they agree to:
A) a one-time currency exchange equal to the principal amount borrowed.
B) make payments on each other's borrowings in a different currency.
C) pay to each other any depreciation or appreciation of the currency.
D)exchange fixed-rate interest payments for variable-rate interest payments.

Accepted Answer

When two borrowers engage in a currency swap, they agree to make payments on each other's borrowings in a different currency. For example, if one borrower has borrowed $1 million in USD, and the other borrower has borrowed €800,000 in euros, they can agree to swap payments so that one borrower pays the other in USD, and the other borrower pays the first borrower in euros. This allows them to effectively borrow in a currency that may have better interest rates or more favorable borrowing conditions.

Question 10

In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for:
A) fixed-rate payments in another currency.
B) variable-rate payments in another currency.
C) fixed-rate payments in the same currency.
D)variable-rate payments in the same currency.

Accepted Answer

In an interest rate swap, borrowers typically exchange fixed-rate payments for variable-rate payments in the same currency, allowing them to hedge against interest rate fluctuations.

Question 11

As time draws closer to contract expiration, futures contract prices can be expected to:
A) increase as the demand for delivery intensifies.
B) decrease as speculators resolve the uncertainty of prices.
C) move similarly to broad-based market indices, such as the S&P 500.
D)converge upon the spot price.

Accepted Answer

As futures contracts approach their expiration, there is a tendency for futures prices to converge towards the spot price of the underlying asset. This is because as the contract expiration date approaches, the possibility of delivery becomes more likely, and traders will adjust prices to reflect the actual value of the asset at the time of delivery. Therefore, D is the correct answer. A, B, and C are incorrect because they do not reflect the typical price behavior of expiring futures contracts.

Question 12

A gasoline distributor buys a gasoline futures contract that requires acceptance of 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97?
A) A loss of $1,260 is posted to the account.
B) A gain of $1,260 is posted to the account.
C) A loss of $12,600 is posted to the account.
D)A gain of $12,600 is posted to the account.

Accepted Answer

Mark to market = ($2.97 - 2.94) × 42,000 = $1,260; A buyer of a futures contract gains when the closing price rises.

Question 13

One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer:
A) pays a much higher premium than option buyers.
B) has an obligation to purchase, not a choice.
C) can lose no more than the initial premium.
D)has increased rather than reduced risk.

Accepted Answer

The buyer of a futures contract has an obligation to purchase the underlying asset at the agreed upon price and time, while the buyer of an option contract has the choice (but not the obligation) to purchase or sell the underlying asset. Therefore, the futures buyer has a different level of obligation than the option buyer.

Question 14

If managers are rational, they will hedge only when they perceive that:
A) prices are headed in an adverse direction.
B) derivative instruments are priced lower than actual value.
C) risk reduction is preferable to higher potential profits.
D)they can increase their profitability by doing so.

Accepted Answer

Hedging is primarily a risk management strategy used to reduce or limit exposure to uncertain or adverse movements in prices, rather than a tool for speculation or increasing profitability. Managers who are rational would choose to hedge when they prioritize stabilizing their financial outcomes over the pursuit of higher, yet riskier, potential profits.

Question 15

The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration?
A) A loss of $400 is posted to the account.
B) A gain of $400 is posted to the account.
C) A loss of $1,200 is posted to the account.
D)A gain of $1,200 is posted to the account.

Accepted Answer

Mark to market = ($1.44 - 1.41) × 40,000 = $1,200; A seller of a futures contract loses when the closing price rises.

Question 16

ABC Corp. entered into a currency swap with its bank, providing that ABC borrows $5 million at 10% and swaps for a 12% yen loan. The spot exchange rate is ¥105/$. If interest only is to be repaid on an annual basis, how much does ABC pay annually to the bank?
A) ¥1.26 million
B) ¥5.71 million
C) ¥52.50 million
D)¥63.00 million

Accepted Answer

Annual interest payment = ($5 million × ¥105/$) × 0.12 = ¥63 million

Question 17

The typical sequence of cash flows in a futures contract is:
A) purchase price plus a margin account up-front, differences are settled at expiration.
B) margin account up-front, differences are posted daily and settled in cash if margin drops too low.
C) margin account up-front, all differences settled at expiration.
D)all funds are paid at expiration of the contract.

Accepted Answer

In a futures contract, buyers and sellers are required to put up a margin account at the beginning of the contract. Daily settlement prices are calculated to determine if one party owes the other money based on the fluctuation of the price of the underlying asset. If the margin account drops too low, the party is required to post additional funds. At expiration, all outstanding differences are settled in cash. Therefore, the best choice is B.

Question 18

The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper?
A) The price closed down $0.02 per pound.
B) The price closed up $0.02 per pound.
C) The price closed down $0.20 per pound.
D)The price closed up $0.20 per pound.

Accepted Answer

Mark to market = $500 = $x × 25,000; x = $0.02; A seller of a futures contract gains when the closing price declines.

Question 19

Producers who hedge through the purchase of put options must remember that they may be:
A) reducing their profits compared to not hedging.
B) obligated to sell their product at a lower than market price.
C) increasing their overall risk.
D)facing unlimited price risk.

Accepted Answer

Hedging through the purchase of put options allows producers to set a minimum price for their product, protecting against price drops. However, if the market price rises significantly, they might earn less than if they hadn't hedged, as they paid a premium for the put options and are not obligated to sell at the strike price.

Question 20

Hershey's Chocolate is concerned about cocoa prices prior to building inventory for Halloween sales. Analysts project that the price per ton could vary from $2,900 to $3,100. A September call option can be purchased with a $2,950 strike price for a premium of $145. What is Hershey's worst-case scenario if it purchases these options?
A) Cocoa prices will rise to $3,100 and Hershey is protected only to a price of $2,950.
B) Cocoa prices will decline to $2,850 and Hershey will have to pay an extra $100 per ton.
C) Cocoa prices will not rise above Hershey's break-even price of $3,095, which equals the sum of the strike price plus the option premium.
D)Cocoa prices will fall below $2,950 and Hershey will lose $145 per option contract.

Accepted Answer

Hershey's worst-case scenario after purchasing the call options is that cocoa prices fall below the strike price of $2,950. In this case, Hershey would not exercise the option and would lose the premium paid for the option, which is $145 per option contract. This loss occurs because the option becomes worthless if the market price is below the strike price, as Hershey could purchase cocoa at a lower price in the market without exercising the option.

Quiz 24: Risk Management

Managers are willing to pay a price to hedge because:

Why are most futures contracts not settled through delivery of the product?

Financial futures are available to protect against all of the following except:

In general, when deciding whether a market participant needs to buy or sell futures contracts in order to hedge, the rule could be:

How does a soybean farmer lock in a price of $14.40 per bushel when the cash price at harvest is only $14?

Which one of the following statements is correct for an interest rate swap?

Because most hedging acts to reduce risk, managers should expect that hedging will:

Manufacturers who are concerned about volatile commodity prices often use option contracts to alter their risks. What is the worst-case scenario for a seller of put options on corn with a strike price of $4.75 per bushel?

When two borrowers engage in a currency swap, they agree to:

In an interest rate swap, borrowers typically exchange fixed-rate payments in one currency for:

As time draws closer to contract expiration, futures contract prices can be expected to:

A gasoline distributor buys a gasoline futures contract that requires acceptance of 42,000 gallons of gasoline at $2.94 per gallon. How is the account marked to market if gasoline futures close the next day at $2.97?

One distinguishing difference between the buyer of a futures contract and the buyer of an option contract is that the futures buyer:

If managers are rational, they will hedge only when they perceive that:

The seller of a pork bellies futures contract at $1.41 per pound noted that the closing price of pork bellies was $1.44 today. What will happen to this contract, which requires delivery of 40,000 pounds of pork bellies at expiration?

ABC Corp. entered into a currency swap with its bank, providing that ABC borrows $5 million at 10% and swaps for a 12% yen loan. The spot exchange rate is ¥105/$. If interest only is to be repaid on an annual basis, how much does ABC pay annually to the bank?

The typical sequence of cash flows in a futures contract is:

The seller of a copper futures contract noticed that his account was marked with a $500 gain yesterday. If the standardized contract requires delivery of 25,000 pounds of copper, what happened that day to the price of copper?

Producers who hedge through the purchase of put options must remember that they may be: