Exam 29: The Applications of Futures and Options Contracts

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.

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 cross hedging. Cross hedging is common in asset/liability and portfolio management and in hedging a corporate bond issuance. Answer the below questions. (a) Why is cross hedging common? (b) What does it introduce? (c) What two factors determine the effectiveness of a cross hedge?

A long hedge is also known as a buy hedge.

Because the put option buyer gains when the price of the underlying stock index declines, purchasing a ________ will offset any adverse movements in the portfolio's value due to a ________ in the stock market.

In a ________, the objective is to alter a current or anticipated stock portfolio position so that its ________ is zero.

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.

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).