Deck 26: Managing Risk

Question 1

A forward contract is described by:

A) agreeing today to buy a product at a later date at a price to be set in the future
B) agreeing today to buy a product today at its current price
C) agreeing today to buy a product at a later date at a price set today
D) agreeing today to buy a product if and only if its price rises above the exercise price today at its current price

Answer 1

agreeing today to buy a product at a later date at a price set today

Question 2

Insurance companies face the following problems?

A) Administrative costs
B) Adverse selection
C) Moral hazard
D) all of the above

Answer 2

all of the above

Question 3

If you sold a wheat futures contract for $3.75 per bushel and the contract ended at $3.60, how much will you net per bushel? (Ignore transaction costs.)

A) $3.75
B) $0.15
C) $3.60
D) None of the above

Answer 3

$0.15

Question 4

The following are the reasons for firms to undertake risk-reducing transactions is practice:
I. reduce the risk of financial distress
II. reduce the fluctuations in its income
III. mitigate agency costs

A) I only
B) I and II only
C) I, II and III
D) II and III only

Question 5

The risk manager needs to come up with answers to the following questions:
I. what are the major risks that the company is facing and what are the possible consequences?
II. is the company being paid for taking these risks?
III. should we worry about risk at all as risk is God-given?
IV. how should risks be controlled?

A) I only
B) I and II only
C) I, II and IV only
D) III only

Question 6

The type of risk associated with a forward contract is called:

A) market risk
B) default risk
C) currency risk
D) counterparty risk

Question 7

The term "Derivatives" refers to:
I. Forwards
II. Futures
III. Swaps
IV. Option

A) I and II only
B) I, II, and III only
C) III and IV only
D) I, II, III, and IV

Question 8

Insurance companies have some advantages in bearing risk; these include:
I. Superior ability to estimate the probability of loss
II. Extensive experience and knowledge about how to reduce the risk of a loss
III. The ability to pool risks and thereby gain from diversification
IV. Insurance companies cannot diversify away market or macroeconomic risks

A) I, II, and III only
B) II only
C) III only
D) IV only

Question 9

The following futures contracts are traded on the Chicago Board of Trade (CBOT):
I. U.S. Treasury bonds
II. German government bonds (bunds)
III. Swaps
IV. U.S. Treasury bills

A) I only
B) I and II only
C) I, II and III only
D) IV only

Question 10

Derivatives can be used either to hedge or to speculate. These actions:

A) Increase risk in both cases
B) Decrease risk in both cases
C) Spread or minimize risk in both cases
D) Offset risk by hedging and increase risk by speculating

Question 11

Ideally, hedging transactions are:

A) Negative NPV transactions
B) Positive NPV transactions
C) Zero-NPV transactions
D) None of the above

Question 12

In addition to the cost of bearing risk, insurance companies also bear:
I. Administrative costs
II. Moral hazard costs
III. Adverse selection costs

A) I only
B) II only
C) III only
D) I, II, and III

Question 13

When a firm hedges a risk it is:

A) eliminating the risk
B) transferring risk to someone else
C) making the government assume the risk
D) none of the above

Question 14

A derivative is a financial instrument whose value is determined by:

A) a regulatory body such as the FTC
B) the value of an underlying asset
C) hedging a risk
D) speculation

Question 15

The price for immediate delivery is called:

A) forward price
B) exercise price
C) spot price
D) none of the above

Question 16

The seller of a forward contract:

A) agrees to deliver a product at a later date for a price set today
B) agrees to receive a product at a later date at the price on that later date
C) agrees to receive a product at a later date for a price set today
D) agrees to deliver a product at a later date for a price set on that later date

Question 17

When a standardized forward contract is traded on an exchange, it is called:

A) forward contract
B) futures contract
C) options contract
D) none of the above

Question 18

The following futures contracts are traded on the Chicago Mercantile Exchange (CME):
I. U.S. Treasury bonds
II. S&P 500 Index
III. Euro
IV. U.S. Treasury bills

A) I only
B) II, III and IV only
C) II and III only
D) IV only

Question 19

Insurance companies, by issuing Cat bonds (catastrophe bonds) are sharing their risks with:
I. The government
II. Other insurance companies
III. The investors

A) I only
B) II only
C) III only
D) I and II only

Question 20

Investors' do-it-yourself alternative to hedging is:

A) investing in a single stock
B) diversification
C) borrowing and investing in a single stock
D) none of the above

Question 21

If the one-year spot interest rate is 6% and two-year spot interest rate is 7%, calculate the one-year forward interest rate one year from today (approximately):

A) 6%
B) 7%
C) 8%
D) None of the above

Question 22

Banks that have a portfolio of loans generally hedge against default of loans by:

A) negotiating default swap on each individual loan
B) buying credit option on each individual loan
C) negotiate a portfolio default swap, which provides protection on the entire portfolio
D) none of the above

Question 23

A firm owns an asset A and it wants to hedge against changes in the value of A by making an offsetting sale of asset B. The firm minimizes risk if:

A) Selling the same number of units of B as assets of A
B) Selling hedge ratio (delta) number of units of B
C) Selling the reciprocal of hedge ratio number of units of B
D) None of the above

Question 24

The current level of Standard & Poor's index is 500. The prospective dividend yield is 2%, and the interest rate is 6%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.)

A) 530
B) 520
C) 540
D) None of the above

Question 25

What investment would be a hedge for a corn farmer?

A) Long corn put option
B) Long corn call option
C) Long corn futures
D) None of the above

Question 26

If you bought eight contracts of Euro currency futures (i.e. total of one million Euros) with an initial margin of $2835 per contract. You buy the contracts at $1.3468/Euro and after a few days of trading ends at a price of $1.3534/Euro with the following ending price each day:
$1)3465, $1.3443, $1.3434 and $1.3534. What would be the margin account value sequence be? Starting value being $22,680 .

A) $22,680, $22,180, $20,380, $19,280, $29,280
B) $22,680, $22,380, $20,180, $19,280, $29,280
C) $22,680, $22,180, $19,280, $22,380, $29,280
D) none of the above

Question 27

The current level of Standard and Poor's index is 950. The prospective dividend yield is
3%, and the interest rate is 5%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.)

A) 969
B) 997.5
C) 978.5
D) None of the above

Question 28

Suppose you borrow $95.24 for one year at 5% and invest $95.24 for two years at 7%. For the time period beginning one year from today, you have: (approximately)

A) Borrowed at 7%
B) Invested at 7%
C) Borrowed at 9%
D) Invested at 9%

Question 29

The spot price for delivery of home heating oil is $0.55 per gallon. The futures price for one year from now is $0.57. If the risk-free rate is 6% per year, what is the net convenience yield?

A) 0.0411
B) 0.0364
C) 0.0236
D) 0.044

Question 30

First National Bank has made a 5-year, $100 million fixed-rate loan at 10%. Annual interest payments are $10 million, and all principal will be repaid in year 5. The bank wants to swap the fixed interest payment into floating-rate payments. If the bank could borrow at a fixed rate of 8% for 5 years, what is the notional principal of the swap?

A) $80 million
B) $100 million
C) $125 million
D) $180 million

Question 31

The spot price of wheat is $2.90/bushel. One year futures price is $3.00/bushel. If the risk- free rate is 5%, calculate the net convenience yield.

A) -0.019
B) +0.019
C) +0.0345
D) None of the above

Question 32

Futures trading eliminates:

A) market risk
B) counterparty risk
C) default risk
D) none of the above

Question 33

The current level of S & P 500 index is 1100. The prospective dividend yield is 3%, and the current interest rate is 7%. What is the value of a one-year futures contract on the index? (Assume all dividends are paid at the end of the year.)

A) 1177
B) 1144
C) 1133
D) None of the above

Question 34

The relationship between the spot and futures prices of financial futures is given by:

A) [Futures price] = Spot price(1 + rf)^t (where rf = risk-free rate)
B) [Futures price] = Spot price (1 + rf - y)^t (where y = dividend yield or interest rate)
C) [Futures price] = Spot price (1 + rm)^t (where rm = market rate of return)
D) None of the above

Question 35

If you sold a futures contract for $3.75 per bushel and the contract ended at $3.60 after several days of trading of $3.80, $3.70, $3.65, $3.70, $3.65 and $3.60. What would the mark to market sequence be?

A) -0.05, 0.10, 0.05, -0.05, 0.05, 0.05
B) 0.05, -0.10, -0.05, 0.05, -0.05, -0.05
C) -0.05, 0.05, 0.10, 0.05, -0.09, -0.15
D) 0.05, -0.05, -0.10, -0.05, -0.09, -0.015

Question 36

In a "total return swap" the asset might be a:
I. common stock
II. loan
III. commodity
IV. market index

A) I and II only
B) I, II and III only
C) I, II, III and IV
D) IV only

Question 37

Firm A is paying a fixed $700,000 in interest payments, while Firm B is paying LIBOR plus 50 basis points on $10,000,000 loans. The current LIBOR rate is 6.25%. Firm A and B have agreed to swap interest payments, how much will be paid to which Firm this year?

A) A pays $750,000 to Firm B
B) B pays 25,000 to Firm A
C) B pays $50,000 to Firm A
D) A pays $25,000 to Firm B

Question 38

If the one-year spot interest rate is 8% and two-year spot interest rate is 9%, calculate the one-year forward interest rate one year from today (approximately):

A) 10%
B) 12%
C) 14%
D) None of the above

Question 39

Third National Bank has made 10-year, $25 million fixed-rate loan at 12%. Annual
Interest payments are $3 million, and all principal will be repaid in year 10. The bank wants to swap the fixed interest payments into floating-rate payments. If the bank could borrow at a fixed rate of 10% for 10 years, what is the notional principal of the swap?

A) $40 million
B) $20 million
C) $25 million
D) $30 million

Question 40

A forward interest rate contract is called a

A) Forward contract
B) Forward Rate Agreement
C) Futures Rate Agreement
D) None of the above

Question 41

Options contracts are marked to market.

Question 42

What are the disadvantages faced by the insurance companies in bearing risk?

Question 43

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 7.5% which is the average of the two rates.

Question 44

Convenience yield is the extra value created by holding the actual commodity rather than a financial claim on it.

Question 45

Briefly explain the term "derivatives."

Question 46

Derivative instruments are those whose value depends on the value of another asset.

Question 47

Briefly explain the mechanics of homemade forward rate agreements.

Question 48

Briefly explain the term "marked to market."

Question 49

For commodity futures: (Futures price)(1 + rf)^t = Spot price-net convenience yield.

Question 50

If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 9%.
One year loan one year from today: [(1.08)^2/(1.07)] - 1 = 0.09 = 9%

Question 51

For financial futures, (Spot price)/(1 + rf - y)^t = Futures price.

Question 52

For commodity futures, net convenience yield = (convenience yield - storage costs).

Question 53

Disadvantages faced by insurance companies in bearing risk are: administrative costs, adverse selection and moral hazard.

Question 54

Are companies that trade in derivatives speculating?

Question 55

Hedging requires an offsetting position.

Question 56

"Mark to market" means that each day any profits or losses are calculated and your account is adjusted accordingly.

Question 57

What are the four basic types of contracts or instruments used in financial risk management?

Question 58

In a rising market, more derivatives investors will make money than lose money.

Question 59

Hedge ratio or delta measures the sensitivity of the value of one asset relative to the value of another asset.

Question 60

A company that wishes to lock in an interest rate on future borrowing can either enters into a FRA or it can borrow long-term funds and lend short-term.

Question 61

Why are derivatives necessary for a thriving economy?

Question 62

Briefly explain how options can be used for hedging.

Question 63

Explain how a firm wishing to invest in floating rate investments can use a swap to manage its interest rate exposure?

Question 64

What is the difference between hedging, speculation, and arbitrage?

Question 65

Briefly explain swaps.