Deck 7: Managing Interest Rate Risk Using Off-Balance-Sheet Instruments

Question 1

Which of the following statements is true?

A)Using a futures or forward contract to hedge a specific asset or liability risk is called macrohedging.
B)Using a futures or forward contract to hedge a specific asset or liability risk is called microhedging.
C)Using a futures or forward contract to hedge a specific asset or liability risk is called asset- or liability-specific hedging.
D)Using a futures or forward contract to hedge a specific asset or liability risk is called naïve hedging.

Answer 1

B

Question 2

The dollar value of the outstanding futures position depends on the:

A)number of contracts bought and sold and the price of each contract
B)cash exposure ratio
C)number of contracts bought and sold and the change in interest rates
D)contracts that should be sold per dollar of cash exposure

Answer 2

A

Question 3

Which of the following are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a pre-specified price for a specified time period?

A)options
B)futures
C)forwards
D)swaps

Answer 3

A

Question 4

Which of the following statements is true?

A)Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each hour to reflect current futures market conditions.
B)Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions.
C)Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each week to reflect current futures market conditions.
D)Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each month to reflect current futures market conditions.

Question 5

Which of the following statements is true?

A)If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a dollar hedge.
B)If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a plain hedge.
C)If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a naïve hedge.
D)All of the listed options are correct.

Question 6

Which of the following is an adequate definition of conversion factor?

A)A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is delivered to the buyer.
B)A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the buyer.
C)A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is delivered to the seller.
D)A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the seller.

Question 7

Which of the following statements is true?

A)Routine hedging seeks to hedge all interest rate risk exposure.
B)Routine hedging seeks to hedge all foreign exchange rate risk exposure.
C)Routine hedging seeks to hedge all liquidity risk exposure.
D)Routine hedging seeks to hedge all capital risk exposure.

Question 8

Which of the following is a major difference between forwards and futures?

A)Forwards are marked to market, while futures are not.
B)Futures are tailor made, while forwards are standardised.
C)The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against credit risk, while this is not the case for forwards.
D)Forwards are marked to market, while futures are not, futures are tailor made, while forwards are standardised and the default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against credit risk, while this is not the case for forwards.

Question 9

...is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract.

A)Macro risk
B)Micro risk
C)Basis risk
D)Duration risk

Question 10

Which of the following statements is true?

A)In equity markets, delivery and cash settlement normally occur two business days after the spot agreement.
B)In equity markets, delivery and cash settlement normally occur three business days after the spot agreement.
C)In equity markets, delivery and cash settlement normally occur four business days after the spot agreement.
D)In equity markets, delivery and cash settlement normally occur five business days after the spot agreement.

Question 11

Partially hedging the gap or individual assets and liabilities is referred to as?

A)hedging arbitrarily
B)hedging selectively
C)hedging partially
D)hedging naively

Question 12

A ...is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

A)call option
B)put option
C)forward contract
D)futures contract

Question 13

A ...is a (non-standard) contract between two parties to deliver and pay for an asset in the future.

A)call option
B)put option
C)forward contract
D)swap

Question 14

Within the futures market, to be fully hedged means:

A)Buying a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
B)Selling a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
C)Selling a sufficient number of futures contracts so that the gain of net worth on the FI's balance sheet when interest rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
D)None of the listed options are correct.

Question 15

A ...is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be exchanged for cash at some later date.

A)call option
B)put option
C)forward contract
D)swap

Question 16

Which of the following statements is true?

A)Microhedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
B)Macrohedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
C)Microhedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.
D)Macrohedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.

Question 17

In a 'plain Vanilla swap' the swap buyer agrees to make:

A)fixed-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the use of derivatives to turn it into a fixed-rate loan
B)fixed-interest payments to the swap seller on a loan that is originally fixed, but which is then modified through the use of derivatives to turn it into a floating-rate loan
C)floating-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the use of derivatives to turn it into a fixed loan
D)None of the listed options are correct.

Question 18

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

A)Hedging
B)Marking to market
C)Arbitrage
D)Securitisation

Question 19

An undeliverable futures contract refers to a futures contract in which:

A)there is no physical settlement
B)there is no mandatory cash settlement
C)one of the parties is unable to deliver
D)money has been lost due to a party having chosen an unfavourable hedging strategy

Question 20

The final settlement in which all bought and sold futures contracts in existence at the close of trading in the contract month are settled at the cash settlement price is called a:

A)periodical cash settlement
B)mandatory cash settlement
C)monthly cash settlement
D)final cash settlement

Question 21

In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities.In June, the 91-day Treasury bill rate is 5.50 per cent.If the investor uses 10 T-bill futures contracts to hedge the interest rate risk, should she take a long or a short hedge? What are the returns on the futures hedge if there is no basis risk?

A)She earns $30 000 on the short futures hedge.
B)She earns $30 000 on the long futures hedge.
C)She earns $7500 on the short futures hedge.
D)She earns $7500 on the long futures hedge.

Question 22

Which of the following statements is true?

A)The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the position is called value risk.
B)The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the position is called basis risk.
C)The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the position is called gap risk.
D)The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the position is called fundamental risk.

Question 23

Which of the following statements is true?

A)In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the buyer 'at that time'.
B)In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a future point in time, for example, after three months.
C)In a futures contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily basis, and the buyer pays the futures price quoted at expiry.
D)None of the listed options are correct.

Question 24

Assume that the price paid by the buyer of a forward is $82 000 and further assume that the spot price of purchasing the hedged underlying asset at delivery date is $85 000.What is the result for the forward seller?

A)The result is a $3000 profit.
B)The result is a $3000 loss.
C)The answer depends on how the forward price develops over time.
D)There is too little information to answer the question.

Question 25

An Australian bank must pay US$10 million in 90 days.It wishes to hedge the risk in the futures market.To do so, the bank should:

A)buy A$10 million in US dollar futures
B)sell A$10 million in US dollar futures, with three-month maturity
C)buy US$10 million in US dollar futures
D)sell US$10 million in US dollar futures

Question 26

A company is considering using futures contracts to hedge an identified interest rate exposure on its debt facilities.However, it is concerned about the impact of basis risk.All of the following statements regarding basis risk are correct, except:

A)basis risk is the difference between prices in the physical market and the price of the relevant futures market contract.
B)the existence of basis risk removes the opportunity for a perfect borrowing hedge.
C)initial basis will be evident while the market is of the view that physical market prices will remain stable.
D)final basis will exist where a futures contract is used to hedge a risk associated with a different physical market product.

Question 27

Which of the following statements is true?

A)In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the mark-to-market process.
B)In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the mark-to-market process.
C)In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the mark-to-book value process.
D)In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the mark-to-book value process.

Question 28

Which of the following statements is true?

A)Micro- and macrohedging always lead to the same hedging strategies and results.
B)Micro- and macrohedging can lead to the same hedging strategies but will lead to different results.
C)Micro- and macrohedging will lead to different hedging strategies but will also lead to the same results.
D)Micro- and macrohedging can lead to different hedging strategies and results.

Question 29

Which of the following statements is true?

A)In a spot contract the buyer and seller enter into a contract at time 0, the contract is marked to market, the seller agrees on a price at time 0 and the bonds is delivered by the seller to the buyer 'at that time'.
B)In a spot contract the buyer and seller agree on a price at time 0 and the bonds is delivered by the seller at a future point in time, for example, after three months.
C)In a spot contract the buyer and on a daily basis, and the buyer pays the spot price quoted at expiry.
D)None of the listed options are correct.

Question 30

Which of the following statements is true?

A)A very actively traded spot contract is the spot rate agreement (SRA).
B)A very actively traded spot contract is the futures rate agreement (FRA).
C)A very actively traded forward contract is the forward rate agreement (FRA), commonly used to lock in the interest rate on shorter term borrowings.
D)A very actively traded spot contract is the option rate agreement (ORA), commonly used to grant the right to buy or sell an asset at a specified price.

Question 31

The benefit of a futures exchange is:

A)elimination of customer risk exposure
B)provision of clearing services
C)guarantee of trading volume
D)intervention on the trader's behalf with government regulators

Question 32

Which of the following statements is true?

A)The advantage of using forwards for creating a synthetic fixed rate position is that there are no cash flows until the contract matures.
B)The advantage of using futures for creating a synthetic fixed rate position is that futures contracts are standardised.
C)The advantage of using forwards for creating a synthetic fixed rate position is that futures contracts are standardised.
D)The advantage of using futures for creating a synthetic fixed rate position is that there are no cash flows until the contract matures.

Question 33

Financial futures are used by FIs to manage:

A)credit risk
B)interest rate risk
C)liquidity risk
D)sovereign country risk

Question 34

Which of the following statements is true?

A)In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the buyer 'at that time'.
B)In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a future point in time, for example, after three months.
C)In a forward contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily basis, and the buyer pays the forward price quoted at expiry.
D)None of the listed options are correct.

Question 35

Which of the following is a common use of FRAs?

A)To lock in an interest rate on relatively shorter term borrowings.
B)To lock in an interest rate on medium-term borrowings.
C)To lock in an interest rate on relatively longer term borrowings.
D)To lock in an interest rate on any term of borrowings.

Question 36

An FI portfolio manager holds 10-year $1 million face value bonds.At time 0, these bonds are valued at $95 per $100 of face value and the manager expects interest rates to rise over the next three months.What should the manager do?

A)The FI portfolio manager should leave the position untouched as changes in the interest rate have no impact on bond prices.
B)The FI portfolio manager should leave the position untouched as an increase in interest rates will lead to higher bond prices.
C)The FI portfolio manager should hedge the position by selling a three months forward contract with a face value of $1 million.
D)The FI portfolio manager should hedge the position by buying a three months forward contract with a face value of $1 million.

Question 37

Which of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract?

A)Forward contracts are classified as exotic derivatives.
B)Margin requirements on futures.
C)More flexibility as the buyer can decide whether or not to exercise the contract at maturity.
D)None of the listed options are correct, as the default risk of a futures contract is generally considered to be higher than that of a forward contract.

Question 38

In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities.In June, the 91-day Treasury bill rate is 5.50 per cent.What is the investor's profit (loss) if the 91-day rate falls to 5.20 per cent in September?

A)The investor loses $30 000 because of the 30 basis point decline in interest rates.
B)The investor gains $30 000 because of the 30 basis point decline in interest rates.
C)The investor gains $7583 because of the 30 basis point decline in interest rates.
D)The investor loses $7583 because of the 30 basis point decline in interest rates.

Question 39

A forward contract:

A)has more credit risk than a futures contract
B)is more standardised 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 40

Which of the following is true of the market price of a futures contract over time?

A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It decreases with time to expiration.

Question 41

What is a swap?

A)An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval.
B)An agreement between a buyer and a seller at time 0 to exchange a non-standardised asset for cash at some future date.
C)A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time.
D)Trading in securities prior to their actual issue.

Question 42

A futures contract:

A)is tailor made to fit the needs of the buyer and the seller
B)has more price 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

Question 43

A call option is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be exchanged for cash at some later date.

Question 44

A forward contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

Question 45

Forwards are on-balance-sheet transactions.

Question 46

Which of the following best describes a derivative contract?

A)Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C)Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future.
D)Trading in securities prior to their actual issue.

Question 47

What kind of interest rate swap (of liabilities) would an FI with a positive funding gap utilise to hedge interest rate risk exposure?

A)swap in floating-rate payments for fixed-rate payments
B)swap in floating-rate receipts for fixed-rate payments
C)swap in fixed-rate receipts for floating-rate receipts
D)swap in floating-rate receipts for fixed-rate receipts

Question 48

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)over-hedging

Question 49

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.

Question 50

In a put option on a bond, the:

A)seller of the put option is committed to receive the underlying bond at a specified time
B)buyer of the put option is committed to handing over the specified bond at a specified time to the seller of the option
C)buyer of the option is committed to receive the underlying bond at a specified time
D)seller of the bond is committed to handing over the specified bond at a specified time

Question 51

Which of the following statements is true?

A)In Australian interest rate futures there is no physical settlement of either 10-year or three-year bond futures.
B)In Australian interest rate futures there is no physical settlement of either 10-year or five-year bond futures.
C)In Australian interest rate futures there is no physical settlement of either five-year or three-year bond futures.
D)In Australian interest rate futures there is always physical settlement.

Question 52

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 organised exchange, while most futures contracts are OTC contracts.
C)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 SFE.
D)Delivery of the underlying asset almost always occurs on a futures contract but almost never occurs on a forward contract.

Question 53

A major difference between a forward and a futures contract:

A)is the forward has less credit risk than a futures contract
B)is the forward contract is tailor-made to fit the needs of the buyer
C)is the forward contract is marked to market more frequently than a futures contract
D)is the forward contract rarely has final delivery of the asset

Question 54

A futures contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

Question 55

The writer of a bond call option:

A)receives a premium and must stand ready to sell the bond at the exercise price
B)receives a premium and must stand ready to buy bonds at the exercise price
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price

Question 56

Which of the following statements is true?

A)Over-hedging will lead to a significant reduction in risk, but also in returns.
B)In terms of risk and return, there is a linear relationship between an unhedged, a selectively hedged, a fully hedged and an over-hedged position.
C)It is not possible to over-hedge a position.
D)Over-hedging will lead to a significant reduction in risk, but also in returns, in terms of risk and return, there is a linear relationship between an unhedged, a selectively hedged, a fully hedged and an over-hedged position and it is not possible to over-hedge a position.

Question 57

A forward contract is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be exchanged for cash at some later date.

Question 58

As interest rates increase, the writer of a bond call option stands to make:

A)limited gains
B)limited losses
C)unlimited losses
D)unlimited gains

Question 59

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

Question 60

The buyer of a bond call option:

A)receives a premium in return for standing ready to sell the bond at the exercise price
B)receives a premium in return for standing ready to buy bonds at the exercise price
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price

Question 61

It is possible to create a synthetic fixed-rate position from floating-rate instruments using futures contracts.Forward contracts cannot be used.

Question 62

An interest rate swap is a succession of forward contracts on interest rates arranged by two parties that allows for the exchange of fixed-interest payments for floating payments; as such, it allows an FI to place a long-term hedge.

Question 63

Some futures exchanges have deliverable bond futures, meaning that at the contract's expiry holders of bought futures positions must take physical delivery and sellers must make delivery.

Question 64

The Sydney Futures Exchange only offers cash-settled contracts.

Question 65

Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

Question 66

In a put option, the purchaser of the bond option is committed to handing over the specified bond at a specified time.

Question 67

For a currency that has a futures contract, basis risk is not typically a problem as $1 is the same as any other $1.

Question 68

Off-market swaps are swaps that are have non-standard terms that require one party to compensate another so the swap can be tailored to the needs of the transacting parties; compensation is usually in the form of an upfront fee or payment.

Question 69

Explain how hedging affects risk and return.Use a diagram to stress your points.In your answer differentiate between routine hedging and hedging selectively.

Question 70

When calculating the number of hedges required for a position, the number should always be rounded up to cover the full position.

Question 71

Explain the differences between using futures and options contracts to hedge interest rate risk.Use diagrams where possible to support your points.

Question 72

Basis risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract.

Question 73

Firm-specific risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract.

Question 74

Buying a call option (standing ready to buy bonds at the exercise price) is a strategy that an FI may take when bond prices rise and interest rates are expected to fall.

Question 75

All call options are eventually exercised and the underlying asset must be delivered.