Question 1

What is basis risk? What are the sources of basis risk?

Accepted Answer

Basis risk is the degree to which fluctuations in the basis are unpredictable,given perfect foresight about the path the price takes in the future.Since the basis is simply the difference between the futures (or forward)price and the spot price,basis risk is also the degree to which the futures (or forward)price is unpredictable,given perfect foresight about the path the spot price will take.Basis risk may arise because investors are irrational,or face market frictions that prevent them from arbitraging a mispriced futures or forward contract.Basis risk may also arise because changes in interest rates are unpredictable.While this eliminates the ability to arbitrage any deviation from the futures-spot pricing relation,the effect on the pricing relation and on hedge ratios has to be negligible.Finally,basis risk may arise because of variability in convenience yields that is not determined by changes in the spot price of the commodity.Convenience yield risk of this type is unhedgeable,and eliminates not only the ability to perfectly hedge long-term obligations with short-term forwards,but also the ability to arbitrage deviations from the forward spot pricing relation.It is largely this unhedgeable convenience yield risk that the analyst needs to be concerned about when estimating hedge ratios.

Question 2

Which of the following is true of the tailing of the hedge?

Accepted Answer

A) Long-dated obligations hedged with short-term forward agreements need to be tailed if the underlying commitment does not have a convenience yield. 
B) The degree of tail will have no influence on convenience yield as it makes the receipt of a commodity at a future date less risky compared to receiving it now. 
C) Long-dated obligations hedged with long-term forward agreements need to be tailed if the underlying commitment does not have a convenience yield. 
D) When hedging with futures,a greater degree of tailing is needed depending on the convenience yield earned. 
A) Long-dated obligations hedged with short-term forward agreements need to be tailed if the underlying commitment does not have a convenience yield. 
B) The degree of tail will have no influence on convenience yield as it makes the receipt of a commodity at a future date less risky compared to receiving it now. 
C) Long-dated obligations hedged with long-term forward agreements need to be tailed if the underlying commitment does not have a convenience yield. 
D) When hedging with futures,a greater degree of tailing is needed depending on the convenience yield earned. D

Question 3

_____ is the practice of selling less than one financial contract to hedge one unit of the spot asset.

Accepted Answer

A) Value hedging 
B) Money market hedging 
C) Tailing the hedge 
D) Rolling hedge 
A) Value hedging 
B) Money market hedging 
C) Tailing the hedge 
D) Rolling hedge C

Question 4

Which of the following is true of value at risk (VAR)?

Accepted Answer

A) It can be applied only at a significance level of 5%. 
B) The shorter the time horizon,the more spread out is the normal distribution curve of the VAR. 
C) It is the percentage of the portfolio which is not invested in the risk-free assets. 
D) It is the worst loss possible under normal market conditions for a given time horizon. 
A) It can be applied only at a significance level of 5%. 
B) The shorter the time horizon,the more spread out is the normal distribution curve of the VAR. 
C) It is the percentage of the portfolio which is not invested in the risk-free assets. 
D) It is the worst loss possible under normal market conditions for a given time horizon.

Question 5

Define convenience yield.

Accepted Answer

From a valuation perspective,most commod

Question 6

A one-year futures contract is riskier than a one-year forward contract because:

Accepted Answer

A) futures contracts are not regulated. 
B) forward contracts are traded through organized exchanges. 
C) futures are mark-to-market. 
D) there is arbitraging opportunities associated with the futures contract. 
A) futures contracts are not regulated. 
B) forward contracts are traded through organized exchanges. 
C) futures are mark-to-market. 
D) there is arbitraging opportunities associated with the futures contract.

Question 7

A money market hedge:

Accepted Answer

A) involves borrowing one currency on a short-term basis and converting it to another currency immediately. 
B) is the hedging technique in which money market instruments are hedged by taking a long position in subordinate tranches and a short position in senior tranches. 
C) is the practice of selling less than one financial contract to hedge one unit of the spot assets. 
D) is the acquisition of financial instruments that alter the factor betas of the firm?s equity return in order to reduce the firm's equity return risks. 
A) involves borrowing one currency on a short-term basis and converting it to another currency immediately. 
B) is the hedging technique in which money market instruments are hedged by taking a long position in subordinate tranches and a short position in senior tranches. 
C) is the practice of selling less than one financial contract to hedge one unit of the spot assets. 
D) is the acquisition of financial instruments that alter the factor betas of the firm?s equity return in order to reduce the firm's equity return risks.

Question 8

In an off-market contract:

Accepted Answer

A) there is no chance of arbitraging. 
B) cash is exchanged at the contract?s inception. 
C) an exchange will act as an intermediary between the buyer and the seller. 
D) there is no obligation on either the buyer or the seller. 
A) there is no chance of arbitraging. 
B) cash is exchanged at the contract?s inception. 
C) an exchange will act as an intermediary between the buyer and the seller. 
D) there is no obligation on either the buyer or the seller.

Question 9

Which of the following is true of convenience yield?

Accepted Answer

A) It is the benefit or premium from holding a financial instrument such as forward contracts and options. 
B) It is the benefit from holding an inventory of the commodity net of its direct storage costs. 
C) Convenience yields affect forward or futures hedge ratios when the maturity of the future obligation hedged matches the maturity of the futures or forward contract used to hedge. 
D) The futures or forward contracts used to hedge the commodity would not vary depending on the date of the future obligation. 
A) It is the benefit or premium from holding a financial instrument such as forward contracts and options. 
B) It is the benefit from holding an inventory of the commodity net of its direct storage costs. 
C) Convenience yields affect forward or futures hedge ratios when the maturity of the future obligation hedged matches the maturity of the futures or forward contract used to hedge. 
D) The futures or forward contracts used to hedge the commodity would not vary depending on the date of the future obligation.

Question 10

In a covered option strategy:

Accepted Answer

A) one option is issued or bought per unit of the asset or liability generating the risk exposure. 
B) the option's delta ($\Delta$)is first calculated and then options in the quantity 1/$\Delta$ are issued or bought per unit of the asset or liability. 
C) a call option is bought and a put option is written to hedge risk. 
D) the risk of a call option is covered by buying or selling a put option. 
A) one option is issued or bought per unit of the asset or liability generating the risk exposure. 
B) the option's delta ($\Delta$)is first calculated and then options in the quantity 1/$\Delta$ are issued or bought per unit of the asset or liability. 
C) a call option is bought and a put option is written to hedge risk. 
D) the risk of a call option is covered by buying or selling a put option.

Question 11

Compare and contrast simulation method and regression method.

Accepted Answer

The regression method,one of the most po

Question 12

Which of the following is true of the comparison between simulation and regression?

Accepted Answer

A) The simulation method requires much more judgement on the part of the analyst than regression. 
B) The simulation method requires that the past history of the firm provide the best estimate of the future than regression. 
C) The simulation method is inferior to regression estimation using historical data. 
D) The simulation method is a backward-looking method of estimating risk exposure,whereas regression method is forward-looking. 
A) The simulation method requires much more judgement on the part of the analyst than regression. 
B) The simulation method requires that the past history of the firm provide the best estimate of the future than regression. 
C) The simulation method is inferior to regression estimation using historical data. 
D) The simulation method is a backward-looking method of estimating risk exposure,whereas regression method is forward-looking.

Question 13

Which of the following is true of hedging with interest rate swaps?

Accepted Answer

A) The present value of the floating side of the swap has virtually no sensitivity to interest rate risk. 
B) The present value of the fixed side of the swap has a different interest rate risk as compared to a fixed-rate bond. 
C) A swap to pay a fixed rate of interest and receive a floating rate of interest generates greater interest rate sensitivity than the issuance of a fixed-rate bond. 
D) A swap to pay a floating interest rate and receive a fixed interest rate generates greater interest rate sensitivity than the purchase of a fixed-rate bond. 
A) The present value of the floating side of the swap has virtually no sensitivity to interest rate risk. 
B) The present value of the fixed side of the swap has a different interest rate risk as compared to a fixed-rate bond. 
C) A swap to pay a fixed rate of interest and receive a floating rate of interest generates greater interest rate sensitivity than the issuance of a fixed-rate bond. 
D) A swap to pay a floating interest rate and receive a fixed interest rate generates greater interest rate sensitivity than the purchase of a fixed-rate bond.

Question 14

Basis risk:

Accepted Answer

A) is the difference between the discounted futures price and the spot price. 
B) is also the degree to which the futures or forward price is unpredictable. 
C) is the sum of the futures price and the spot price. 
D) arises because investors are rational. 
A) is the difference between the discounted futures price and the spot price. 
B) is also the degree to which the futures or forward price is unpredictable. 
C) is the sum of the futures price and the spot price. 
D) arises because investors are rational.

Question 15

Which of the following is a correct property of variance in hedging with regression?

Accepted Answer

A) If the hedging instrument has a negative marginal variance,then a small reduction in the holdings of the financial instrument in the combination reduces variance. 
B) If the hedging instrument has a positive marginal variance,then a small increase in the holdings of the financial instrument reduces the variance of the combination. 
C) When the financial instrument has zero covariance with the combination of the financial instrument and the cash flow,the variance be minimized. 
D) The combination of the cash flow and the hedge instrument that minimizes variance can have either a positive marginal variance or a negative marginal variance with the financial instrument. 
A) If the hedging instrument has a negative marginal variance,then a small reduction in the holdings of the financial instrument in the combination reduces variance. 
B) If the hedging instrument has a positive marginal variance,then a small increase in the holdings of the financial instrument reduces the variance of the combination. 
C) When the financial instrument has zero covariance with the combination of the financial instrument and the cash flow,the variance be minimized. 
D) The combination of the cash flow and the hedge instrument that minimizes variance can have either a positive marginal variance or a negative marginal variance with the financial instrument.

Question 16

Explain how forward contracts are used to hedge currency obligations.

Accepted Answer

Corporations and financial institutions

Question 17

The size of the position per unit of the underlying asset or commodity that achieves minimum risk is known as the _____.

Accepted Answer

A) rolling hedge 
B) hedgelet 
C) hedge ratio 
D) asset ratio 
A) rolling hedge 
B) hedgelet 
C) hedge ratio 
D) asset ratio

Question 18

Which of the following is a fundamental problem associated with futures contracts in hedging?

Accepted Answer

A) Convenience yields affect forward or futures hedge ratios when the maturity of the future obligation hedged matches the maturity of the futures or forward contract used to hedge. 
B) Large amount of cash needs to be exchanged when future contracts are initiated which will offset the hedging benefit. 
C) Compared to forward contracts,there is a higher probability of default associated with futures contracts,which increases the risk of hedging. 
D) Most futures contracts have relatively short maturities which do not help the long-term commitments of corporations. 
A) Convenience yields affect forward or futures hedge ratios when the maturity of the future obligation hedged matches the maturity of the futures or forward contract used to hedge. 
B) Large amount of cash needs to be exchanged when future contracts are initiated which will offset the hedging benefit. 
C) Compared to forward contracts,there is a higher probability of default associated with futures contracts,which increases the risk of hedging. 
D) Most futures contracts have relatively short maturities which do not help the long-term commitments of corporations.

Question 19

Hedging with regression can be viewed as a:

Accepted Answer

A) special case of maximizing variance hedging when the hedging instrument is costless. 
B) special case of minimizing variance hedging when the hedging instrument is costless. 
C) special case of maximizing variance hedging when the hedging instrument is costly but risk-free. 
D) special case of minimizing variance hedging when the hedging instrument is costly but risk-free. 
A) special case of maximizing variance hedging when the hedging instrument is costless. 
B) special case of minimizing variance hedging when the hedging instrument is costless. 
C) special case of maximizing variance hedging when the hedging instrument is costly but risk-free. 
D) special case of minimizing variance hedging when the hedging instrument is costly but risk-free.

Exam 22: The Practice of Hedging

What is basis risk? What are the sources of basis risk?

Which of the following is true of the tailing of the hedge?

_____ is the practice of selling less than one financial contract to hedge one unit of the spot asset.

Which of the following is true of value at risk (VAR)?

Define convenience yield.

A one-year futures contract is riskier than a one-year forward contract because:

A money market hedge:

In an off-market contract:

Which of the following is true of convenience yield?

In a covered option strategy:

Compare and contrast simulation method and regression method.

Which of the following is true of the comparison between simulation and regression?

Which of the following is true of hedging with interest rate swaps?

Basis risk:

Which of the following is a correct property of variance in hedging with regression?

Explain how forward contracts are used to hedge currency obligations.

The size of the position per unit of the underlying asset or commodity that achieves minimum risk is known as the _____.

Which of the following is a fundamental problem associated with futures contracts in hedging?

Hedging with regression can be viewed as a:

Raising Capital

Debt Financing

Equity Financing

Portfolio Tools

Mean-Variance Analysis and the Capital Asset Pricing Model

Factor Models and the Arbitrage Pricing Theory

Pricing Derivatives

Options

Discounting and Valuation

Investing in Risk-Free Projects

Investing in Risky Projects

Allocating Capital and Corporate Strategy

Corporate Taxes and the Impact of Financing on Real Asset Valuation

How Taxes Affect Financing Choices

How Taxes Affect Dividends and Share Repurchases

Bankruptcy Costs and Debt Holder-Equity Holder Conflicts

Capital Structure and Corporate Strategy

How Managerial Incentives Affects Financial Decisions

The Information Conveyed by Financial Decisions

Mergers and Acquisitions

Risk Management and Corporate Strategy

Interest Rate Risk Management

Filters