Deck 23: Futures and Forwards

Question 1

A perfect hedge, or perfect immunization, seldom occurs.

Answer 1

True

Question 2

Immunizing the balance sheet against interest rate risk means that gains (losses) from an off-balance-sheet hedge will exactly offset losses (gains) from the balance sheet position.

Answer 2

True

Question 3

The notational value of derivative contracts for the top 25 derivative users was less than the total current credit risk exposure of those contracts as of 2015.

Answer 3

False

Question 4

Delivery of the underlying asset almost always occurs in the futures market.

Question 5

A forward contract has only one payment cash flow that occurs at the time of delivery.

Question 6

Derivative contracts allow an FI to manage interest rate and foreign exchange risk.

Question 7

Forward contracts are marked-to-market on a daily basis.

Question 8

A futures contract has only one payment cash flow that occurs at the time of delivery.

Question 9

In a forward contract agreement, the quantity of product to be traded, the time of the actual trade and the price are determined at the time of the agreement.

Question 10

An FI with a negative duration gap is exposed to interest rate declines and could hedge its interest rate risk by buying forward contracts.

Question 11

An FI with a positive duration gap is exposed to interest rate declines and could hedge its interest rate risk by buying forward contracts.

Question 12

As of 2015, U.S.commercial banks held over $42 trillion of forward contracts that were listed for trading on the Chicago Mercantile exchange.

Question 13

Futures contracts are the primary security that insurance companies and banks use to hedge interest rate risk prior to originating mortgages.

Question 14

Forward contracts are individually negotiated and, therefore, can be unique.

Question 15

A spot contract specifies deferred delivery and payment.

Question 16

Commercial banks, investment banks, and broker-dealers are the major forward market participants.

Question 17

As of 2015, commercial banks held more forward contracts than futures contracts for trading.

Question 18

The Financial Accounting Standards Board requires that all derivatives be marked-to-market with any losses and gains transparent on FI's financial statements.

Question 19

Federal regulations in the U.S.allow derivatives to be used only by the 25 largest banks.

Question 20

A forward contract specifies immediate delivery for immediate payment.

Question 21

Hedging a specific on-balance-sheet cash position usually will only require more T-bill futures contracts than hedging the same cash position with T-bond futures contracts because the T-bond contract size is only 10 percent as large as large as the T-bill contract.

Question 22

Routine hedging will allow the FI to achieve greater return from the assets and liabilities on the balance sheet.

Question 23

Hedging foreign exchange risk in the futures market may involve uncertainty about all of the transactions necessary to achieve the hedge to fulfillment.

Question 24

An adjustment for basis risk with a value of "br" less than one means that the percent change in the spot rates is greater than the change in rate in the deliverable bond in the futures market.

Question 25

Hedging selectively only a portion of the balance sheet is an attempt to increase the return of the FI by accepting some level of interest rate risk.

Question 26

Tailing-the-hedge normally requires an FI manager to utilize more futures contracts to hedge a cash position than are warranted by the initial analysis.

Question 27

An off-balance-sheet forward position is used to hedge the FI's on-balance-sheet risk exposure.

Question 28

A conversion factor often is used to determine the invoice price on a futures contract when a bond other than the benchmark bond is delivered to the buyer.

Question 29

It is not possible to separate credit risk exposure from the lending process itself.

Question 30

In a credit forward agreement hedge, the loss on the balance sheet cash position is offset completely by the gain on the off-balance-sheet credit forward agreement if the characteristics of the benchmark bond and the bank's loan to the borrower are the same.

Question 31

The sensitivity of the price of a futures contract depends on the duration of the deliverable asset underlying the contract.

Question 32

Microhedging uses futures or forward contracts to hedge the entire balance sheet duration gap.

Question 33

Selective hedging that results in an over-hedged position may be regarded as speculative by regulators.

Question 34

All bonds that are deliverable under a Treasury bond futures contract have a maturity of 20 years and an interest rate of 8 percent.

Question 35

Basis risk occurs when the underlying security in the futures contract is not the same asset as the cash asset on the balance sheet.

Question 36

Hedging effectiveness often is measured by the squared correlation between past changes in the spot asset prices and futures prices.

Question 37

More FIs fail due to credit risk exposure than exposure to either interest rate risk or foreign exchange risk.

Question 38

The hedge ratio measures the impact that tailing-the-hedge will have on the number of contracts necessary to hedge the cash position.

Question 39

Selective hedging occurs by reducing the interest rate risk by selling sufficient futures contracts to offset the interest rate risk exposure of a portion of the cash positions on the balance sheet.

Question 40

Macrohedging uses a derivative contract, such as a futures or forward contract, to hedge a particular asset or liability risk.

Question 41

Which of the following group of derivative securities had the smallest notational value among the top 25 FIs as of 2015?

A)Futures and forwards.
B)Caps, floors, and collars.
C)Options.
D)Swaps.
E)Credit derivatives.

Question 42

Reducing the number of futures contracts that are needed to hedge a cash position because of the interest income that is generated from reinvesting the marked-to-market cash flows generated by the futures contract is referred to as tail the hedge.

Question 43

The use of futures contracts by banks is subject to risk-based capital guidelines through the off-balance-sheet risk calculations for risk-based capital.

Question 44

An agreement between a buyer and a seller at time 0 to exchange a pre-specified asset for cash at a specified later date is the characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 45

What is a difference between a forward contract and a future contract?

A)The settlement price of a forward contract is fixed over the life of the contract but in a futures contract is marked to market daily.
B)Forward contracts are normally arranged through an organized exchange, while most futures contracts are OTC contracts.
C)Both are essentially the same, except for trading volumes which are higher for futures contracts.
D)Both are essentially the same, except for the fact that the terms of a forward contract is set by the exchange, subject to the approval of the Commodity Futures Trading Commission (CFTC).
E)Delivery of the underlying asset almost always occurs on a futures contract but almost never occurs on a forward contract.

Question 46

Which of the following identifies the largest group of derivative contracts as of 2015?

A)Futures.
B)Forwards.
C)Options.
D)Swaps.
E)Credit derivatives.

Question 47

The payoff on a catastrophe futures contract is adjusted for the actual loss ratio of the insurer.

Question 48

A forward contract

A)has more credit risk than a futures contract.
B)is more standardized than a futures contract.
C)is marked to market more frequently than a futures contract.
D)has a shorter time to delivery than a futures contract.
E)is less risky than a futures contract.

Question 49

A credit forward agreement specifies a credit spread on a benchmark U.S.Treasury bond.

Question 50

Which of the following statements regarding a short hedge is true?

A)A short hedge is when an FI takes a short position in a futures contract when rates re expected to rise;
B)The FI loses net worth on its balance sheet if rates rise.
C)A short hedge seeks to hedge the value of its net worth by selling an appropriate number of futures contracts.
D)None of the above statements are true.
E)All of the above statements are true.

Question 51

The Volcker Rule, implemented in April 2014, resulted in only the investment banking arm of a depository institutions to engage in proprietary trading.

Question 52

The process by which the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions is referred to as marking to market.

Question 53

Catastrophe futures are designed to hedge extreme losses of natural disasters for property-casualty insurance companies.

Question 54

An agreement between a buyer and a seller at time 0 to exchange a standardized, pre-specified asset for cash at a specified later date is characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 55

As a result of the Volcker Rule (2014) there was an increase in the use of derivative securities by U.S.depository institutions.

Question 56

A futures contract

A)is tailor-made to fit the needs of the buyer and the seller.
B)has more credit risk than a forward contract.
C)is marked to market more frequently than a forward contract.
D)has a shorter time to delivery than a forward contract.
E)has more price risk than a forward contract.

Question 57

A naïve hedge is when a noncash asset is hedged on an indirect dollar-for-dollar basis with a looking back contract.

Question 58

An agreement between a buyer and a seller at time 0 where the seller of an asset agrees to deliver an asset immediately and the buyer agrees to pay for the asset immediately is the characteristic of a

A)spot contract.
B)forward contract.
C)futures contract.
D)put options contract.
E)call options contract.

Question 59

The uniform guidelines for banks that trade in futures and forwards require a bank to:

A)establish internal guidelines regarding its hedging activity.
B)establish trading limits.
C)disclose large contract positions that materially affect bank risk to shareholders and outside investors.
D)None of the above statements.
E)All of the above statements.

Question 60

Financial futures can be used by FIs to manage

A)credit risk.
B)interest rate risk.
C)liquidity risk.
D)foreign exchange risk.
E)credit risk, interest rate risk, and foreign exchange risk.

Question 61

Which of the following indicates the need to place a hedge?

A)The price movement in the underlying cash asset cannot be forecasted perfectly.
B)The prices of the assets or liabilities are imperfectly correlated over time with the prices on the futures.
C)Basis risk prevents the minimum risk of the portfolio from reaching zero.
D)Treasury has been issuing more shorter-dated bonds to finance U.S.budget deficits.
E)Spot bonds and futures on bonds are traded in different markets.

Question 62

Why does basis risk occur?

A)Changes in the spot asset's price are not perfectly correlated with changes in the price of the asset delivered under a forward or futures contract.
B)The daily marking-to-market process enables an FI manager to close out a futures position by taking an exactly offsetting position.
C)Spot and futures contracts are traded in the same market, and they have the same demand and supply functions.
D)Due to illiquid markets, the equilibrium spot and futures contracts are often mispriced.
E)None of the options.

Question 63

An FI issued $1 million of 1-year maturity floating rate commercial paper.The commercial paper is repriced every three months at the 91-day Treasury bill rate plus 2 percent.What is the FI's interest rate risk exposure and how can it use financial futures and options to hedge that risk exposure?

A)The FI can hedge its exposure to interest rate increases by selling financial futures.
B)The FI can hedge its exposure to interest rate decreases by selling financial futures.
C)The FI can hedge its exposure to interest rate increases by buying financial futures.
D)The FI can hedge its exposure to interest rate increases by buying call options.
E)The FI cannot hedge its exposure to interest rate increases or decreases using financial futures

Question 64

Which of the following is an example of microhedging asset-side portfolio risk?

A)When an FI, attempting to lock in cost of funds to protect itself against a rise in short-term interest rates, takes a short position in futures contracts on CDs.
B)FI manager trying to pick a futures contract whose underlying deliverable asset is not matched to the asset position being hedged.
C)When an FI hedges a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.
D)When an FI manager wants to insulate the value of the institution's bond portfolio fully against a rise in interest rates.
E)When an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap.

Question 65

Historical analysis of recent changes in exchange rates in both the spot and futures markets for a given currency reveals that spot rates are thirty percent more sensitive than futures prices.Given this information, the hedge ratio for this currency is

A)0.70.
B)0.77.
C)1.30.
D)1.43.
E)1.86.

Question 66

When will the estimated hedge ratio be greater than one?

A)When spot rate changes are greater than futures rate changes.
B)When spot rate changes are less sensitive than futures price changes over time.
C)When spot rate changes are equally sensitive as futures price changes over time.
D)When basis risk is absent.
E)When the spot and future exchange rates are expected to move perfectly together.

Question 67

How is a hedge ratio commonly determined?

A)By discounting the optimal number of futures to sell per $1 of cash position using the yield involved.
B)By using the ratio of the most recent spot and futures price changes.
C)By running an ordinary least squares regression of changes in spot prices on changes in futures prices.
D)By using the conversion factor.
E)By squaring the correlation between past changes in spot asset prices and futures prices.

Question 68

The covariance of the change in spot exchange rates and the change in futures exchange rates is 0.6060, and the variance of the change in futures exchange rates is 0.5050.What is the estimated hedge ratio for this currency?

A)0.306.
B)0.694.
C)1.440.
D)1.200.
E)0.833.

Question 69

The primary benefit of a futures exchange is

A)always knowing its exact location.
B)indemnifying counterparties against credit or default risk.
C)guarantee of trading volume.
D)intervention on the trader's behalf with government regulators.
E)availability of free legal services.

Question 70

Futures contracts are standard in terms of all of the following EXCEPT

A)contract size.
B)delivery month.
C)specific asset to be delivered.
D)trading hours.
E)daily price limits.

Question 71

What is overhedging?

A)Selectively hedging a proportion of an FI's balance sheet position.
B)Choosing to bear some interest rate risk as well as credit and FX risks.
C)Reducing the risk to the lowest level possible.
D)Using more hedge vehicles than is necessary to offset the risk in the cash asset.
E)Partially hedging the individual assets and liabilities.

Question 72

Routine hedging

A)is a hedging strategy that occurs on a set, predetermined basis by the FI.
B)always results in excess returns.
C)is a strategy to follow when interest rates are abnormally low.
D)is a strategy used when interest rates are extremely unpredictable.
E)is a strategy to follow when interest rates are abnormally high.

Question 73

The number of futures contracts that an FI should buy or sell in a macrohedge depends on the

A)size of its interest rate risk exposure.
B)direction of its interest rate risk exposure.
C)return risk trade-off from fully hedging that risk.
D)return risk trade-off from selectively hedging that risk.
E)All of the options.

Question 74

The terms of futures contracts traded in the U.S.are set by the exchange on which they propose to be traded, but are subject to approval by the

A)Federal Reserve.
B)Commodity Futures Trading Commission.
C)CME Group (formerly Chicago Mercantile Exchange).
D)Chicago Board of Trade.
E)Securities and Exchange Commission.

Question 75

If a 12-year, 6.5 percent semi-annual $100,000 T-bond, currently yielding 4.10 percent, is used to deliver against a 6-year, 5 percent T-bond at 110-17/32, what is the conversion factor? What would the buyer have to pay the seller?

A)1.1027; $110,531.
B)1.2257; $135,478.
C)1.8370; $253,830.
D)1.3622; $163,339.
E)1.7263; $141,788.

Question 76

If a 16-year 12 percent semi-annual $100,000 T-bond, currently yielding 10 percent, is used to deliver against a 20-year, 8 percent T-bond at 114-16/32, what is the conversion factor? What would the buyer have to pay the seller?

A)1.158; $132,591.
B)1.156; $115,600.
C)1.150; $131,284.
D)1.102; $124,200.
E)1.000; $114,160.

Question 77

The current price of June $100,000 T-Bonds trading on the Chicago Board of Trade is 109-24.What is the price to be paid if the contract is delivered in June?

A)$107,240.
B)$109,240.
C)$109,750.
D)$110,250.
E)$115,760.

Question 78

An FI has reduced its interest rate risk exposure to the lowest possible level by selling sufficient futures to offset the risk exposure of its whole balance sheet or cash positions in each asset and liability.The FI is involved in

A)microhedging.
B)selective hedging.
C)routine hedging.
D)overhedging.
E)speculation.

Question 79

A naive hedge occurs when

A)an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap.
B)a cash asset is hedged on a direct dollar-for-dollar basis with a forward or futures contract.
C)an FI reduces its interest rate or other risk exposure to the lowest possible level by selling sufficient futures to offset the interest rate risk exposure of its whole balance sheet.
D)an FI purchases an insurance cover to the extent of 80% of losses arising from adverse movement in asset prices.
E)All of the options.

Question 80

Which of the following measures the dollar value of futures contracts that should be sold per dollar of cash position exposure?

A)Hedge ratio.
B)Open position.
C)Implied volatility.
D)Payoff.
E)Risk ratio.