Question 1

The writer of an American-style bond call option has the right, but not the obligation, to buy the bond at a preset price until the option expires.

Accepted Answer

The writer of a bond call option has the obligation to sell the bond at a preset price, while the holder of the call option has the right to buy the bond. Therefore, the statement is incorrect as it mistakenly implies that the writer has the right to buy the bond.

Question 2

A spot contract is an immediate delivery versus payment contract.

Accepted Answer

A spot contract is a type of transaction where two parties agree to buy and sell a particular asset at the current market price and settle the payment immediately or within one or two business days. It is also known as a cash transaction.

Question 3

The lack of perfect correlation between spot and futures prices implies that most hedges will have some basis risk.

Accepted Answer

Basis risk arises due to the imperfect correlation between spot and futures prices, which means that a hedge may not perfectly offset the underlying risk exposure. This results in some residual risk, known as basis risk.

Question 4

Futures contracts are not subject to capital requirements for banks, but many forward contracts are.

Accepted Answer

Futures contracts are traded on exchanges and have standardized terms, which reduces credit risk. Therefore, banks are not subject to capital requirements for futures contracts. However, forward contracts are not standardized and are customized between two parties, which increases credit risk. As a result, banks are subject to capital requirements for forward contracts.

Question 5

Swaps are usually the best hedging tool to use to hedge long-term risks of 4 or 5 years or more.

Accepted Answer

Swaps are typically used for longer-term hedging because they involve agreements to exchange cash flows over an extended period of time, such as 4 or 5 years or more. For shorter-term risks, other hedging tools like futures or options may be more appropriate.

Question 6

The buyer of an American-style bond call option has the right, but not the obligation, to sell the bond at a set price until the option expires.

Accepted Answer

The buyer of an American-style bond call option has the right, but not the obligation, to buy the bond at a set price until the option expires. They do not have the right to sell the bond.

Question 7

A bank has a positive repricing gap and wishes to protect its profits from an unfavorable interest rate move. Purchasing a cap will help limit this bank's interest rate risk.

Accepted Answer

The answer of A bank has a positive repricing gap...

Question 8

A bank with a negative repricing gap could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest to effectively reduce its repricing gap.

Accepted Answer

By entering into a swap where the bank pays a fixed rate of interest and receives a variable rate of interest, the bank can effectively reduce its repricing gap by converting some of its fixed-rate assets or liabilities to floating-rate, thus matching some of its fixed-rate liabilities with a floating rate income stream. This hedges against the risk of changes in interest rates and helps the bank manage its interest rate risk exposure.

Question 9

A U.S. corporation has a yen-denominated loan it must repay in 6 months. A long position in yen futures could help offset the corporation's foreign exchange risk.

Accepted Answer

By taking a long position in yen futures, the U.S. corporation can potentially offset the foreign exchange risk of the yen-denominated loan by locking in a favorable exchange rate for the future repayment. This provides a hedge against possible appreciation of the yen against the U.S. dollar, which would increase the cost of the loan repayment for the corporation in dollar terms.

Question 10

A purchaser of a bond call option gains if interest rates fall.

Accepted Answer

When interest rates fall, the value of bonds increase, which makes the underlying bond of the call option more valuable. This results in an increase in the price of the call option, leading to gains for the purchaser.

Question 11

As interest rates fall, bond prices and call option potential profits increase.

Accepted Answer

When interest rates fall, bond prices increase, and when bond prices increase, call option potential profits increase. This is because call options give the holder the right to buy the underlying asset (in this case, a bond) at a fixed price, and as the price of the underlying asset increases (due to falling interest rates), the potential profits from exercising the call option also increase.

Question 12

Buying a cap is similar to buying a call option on bond prices.

Accepted Answer

Buying a cap is similar to buying a call option on interest rates, not bond prices. Caps are financial derivatives that protect against rising interest rates by setting a maximum (cap) rate, while call options on bonds give the holder the right to buy bonds at a specified price, which is more directly related to the bond's price rather than interest rates.

Question 13

Swaps and forwards are subject to contingent risk; exchange-traded futures and options are not.

Accepted Answer

The answer of Swaps and forwards are subject to contingent...

Question 14

A macro hedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable.

Accepted Answer

The answer of A macro hedge is a hedge of...

Question 15

Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another.

Accepted Answer

Basis risk refers to the risk that the prices or values of the underlying spot and the derivatives instrument used to hedge do not move in the same direction or by the same amount, resulting in imperfect hedging and potential losses.

Question 16

An FI with D_A < kD_L may choose to enter into a long-term swap where it pays a fixed rate of interest and receives a variable rate in order to effectively reduce the duration gap.

Accepted Answer

The answer of An FI with D_A < kD_L may...

Question 17

The maximum gain (ignoring commissions and taxes) from buying an at-the-money bond put option is the bond price at time of option purchase less the put premium. The maximum loss is the put premium.

Accepted Answer

This statement is true. When buying an at-the-money bond put option, the maximum gain is calculated by subtracting the put premium from the bond price at the time of option purchase. The maximum loss is limited to the amount of the put premium paid.

Question 18

Gains and losses on a futures contract must be recognized daily.

Accepted Answer

Gains and losses on a futures contract are marked-to-market, meaning they are recognized daily based on the current market value of the contract. This daily recognition of gains and losses ensures that investors can meet margin requirements and avoid defaulting on their positions.

Question 19

Writing a call option on a bond pays off if interest rates rise.

Accepted Answer

When interest rates rise, the price of a bond falls. As a result, the value of a call option on the bond increases, providing a payoff for the option holder. Therefore, writing a call option on a bond pays off if interest rates rise.

Question 20

A fixed-floating interest rate swap is called a plain vanilla swap.

Accepted Answer

This statement is true. A plain vanilla swap is a basic type of interest rate swap in which one party pays a fixed interest rate and the other pays a floating interest rate.

Quiz 23: Managing Risk Off the Balance Sheet With Derivative Securities