Deck 22: The Practice of Hedging

Question 1

Basis risk:

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.

Answer 1

B

Question 2

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

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.

Answer 2

C

Question 3

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

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.

Answer 3

D

Question 4

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

Question 5

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

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 6

In an off-market contract:

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 7

Compare and contrast simulation method and regression method.

Question 8

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

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 9

A money market hedge:

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 10

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

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

Question 11

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

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 12

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

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 convenience yield?

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 14

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

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

Question 15

Explain how forward contracts are used to hedge currency obligations.

Question 16

Hedging with regression can be viewed as a:

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.

Question 17

In a covered option strategy:

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 18

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

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 19

Define convenience yield.