Deck 21: Derivatives and Risk Management

Question 1

Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can lead only to losses.

Answer 1

True

Question 2

An option is a definite agreement leading to a firm completion of the transaction.

Answer 2

False

Question 3

Which of the following statements best describes contracts?

A) One advantage of forward contracts is that they are default free.
B) Futures contracts generally trade on an organized exchange and are marked to market daily.
C) Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.

Answer 3

B

Question 4

Which of the following statements best describes interest rate and reinvestment rate risk?

A) Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.
B) Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
C) Interest rate price risk can be eliminated by holding zero coupon bonds.
D) Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.

Question 5

Suppose the standard size of a copper futures contract is 25,000 pounds each. At initiation of a futures contract, the futures price is $22.50 per pound. At expiration of the futures contract, the copper price is $19.50 per pound. Which of the following is true?

A) The short profits by $3 per pound.
B) The long profits by $3 per pound.
C) Demand for copper has risen relative to its supply.
D) Undetermined

Question 6

A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?

A) buying inverse floaters
B) entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates
C) entering into a short hedge where the bank agrees to sell interest rate futures
D) selling some of the bank's floating-rate loans and using the proceeds to make fixed-rate loans

Question 7

A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT correct?

A) A swap involves the exchange of cash payment obligations.
B) The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
C) Swaps are very often arranged by a financial intermediary, which may or may not take the position of one of the counterparties.
D) A problem with swaps is the short maturities, which has prevented the development of a secondary market.

Question 8

Which of the following are NOT ways risk management can be used to increase the value of a firm?

A) Risk management can help a firm maintain its optimal capital budget.
B) Risk management can reduce the expected costs of financial distress.
C) Risk management can help firms minimize taxes.
D) Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

Question 9

Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

Question 10

Suppose the June 2008, 10-year, $100,000 Government of Canada bond futures contract has a quoted price of 118.72. The notional amount involved is $27,234,486,720. What is the open interest?

A) 186,125
B) 118,720
C) 272,345
D) 229,401

Question 11

Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B?

A) A pays a fixed rate of 9%; B pays LIBOR + 1.5%.
B) A pays a fixed rate of 8.95%; B pays LIBOR + 1.45%.
C) A pays LIBOR plus 1%; B pays a fixed rate of 9.4%.
D) A pays a fixed rate of 7.95%; B pays LIBOR.

Question 12

The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

Question 13

One objective of risk management can be to reduce the volatility of a firm's cash flows.

Question 14

Suppose the quoted price for a June 2008 10-year CGB futures contract has changed from 118.72 to 118.77. What is the corresponding change in value in this futures contract?

A) $70
B) $60
C) $50
D) $30