Chapter 23 Hedging with Financial Derivatives 23.

1 Multiple Choice
1) Financial derivatives include A) stocks. B) bonds. C) futures. D) none of the above. Answer C 2) Financial derivatives include A) stocks. B) bonds. C) forward contracts. D) both !A) and !B). Answer C 3) "hich of the followin# is not a financial derivative$ A) %tock B) Futures C) &ptions D) Forward contracts Answer A ') A contract that re(uires the investor to bu) securities on a future date is called a A) short contract. B) lon# contract. C) hed#e. D) cross. Answer B *) A contract that re(uires the investor to sell securities on a future date is called a A) short contract. B) lon# contract. C) hed#e. D) +icro hed#e. Answer A ,) A lon# contract re(uires that the investor A) sell securities in the future. B) bu) securities in the future. C) hed#e in the future. D) close out his position in the future. Answer B 3-' .) A short contract re(uires that the investor A) sell securities in the future. B) bu) securities in the future. C) hed#e in the future. D) close out his position in the future.

Answer A /) Forward contracts do not suffer fro+ the proble+ of A) a lack of li(uidit). B) a lack of fle0ibilit). C) the difficult) of findin# a counterpart). D) default risk. Answer B 1) B) sellin# short a futures contract of 21--3--- at a price of 11*3 )ou are a#reein# to deliver A) 21--3--- face value securities for 211*3---. B) 211*3--- face value securities for 211-3---. C) 21--3--- face value securities for 21--3---. D) 211*3--- face value securities for 211*3---. Answer A 1-) B) sellin# short a futures contract of 21--3--- at a price of 1,3 )ou are a#reein# to deliver A) 21--3--- face value securities for 21-'31,.. B) 21,3--- face value securities for 21--3---. C) 21--3--- face value securities for 21,3---. D) 1--3--- face value securities for 21--3---. Answer C 11) B) bu)in# a lon# 21--3--- futures contract for 11*3 )ou a#ree to pa) A) 21--3--- for 211*3--- face value bonds. B) 211*3--- for 21--3--- face value bonds. C) 2/,31*, for 21--3--- face value bonds. D) 2/,31*, for 211*3--- face value bonds. Answer B 12) 4f )ou sold a short contract on financial futures3 )ou hope interest rates A) rise. B) fall. C) are stable. D) fluctuate. Answer A 3-* 13) 4f )ou bou#ht a lon# contract on financial futures3 )ou hope that interest rates A) rise. B) fall. C) are stable. D) fluctuate. Answer B 1') 4f )ou sold a short futures contract3 )ou will hope that bond prices A) rise. B) fall.

C) are stable. D) fluctuate. Answer B 1*) 5he eli+ination of riskless profit opportunities in the futures +arket is referred to as A) speculation. B) hed#in#. C) arbitra#e. D) open interest. 6) +ark to +arket. Answer C 1,) Futures contracts are re#ularl) traded on the A) Chica#o Board of 5rade. B) 7ew 8ork %tock 60chan#e. C) A+erican %tock 60chan#e. D) Chica#o Board of &ptions 60chan#e. Answer A 1.) Financial futures are re#ularl) traded on all of the followin# e0cept the A) Chica#o Board of 5rade. B) Chica#o Mercantile 60chan#e. C) 7ew 8ork Futures 60chan#e. D) Chica#o Co++odit) Markets Board. Answer D 1/) 5he a#enc) responsible for re#ulation of the futures e0chan#es and tradin# in financial futures is the A) Co++odit) Futures 5radin# Co++ission. B) %ecurities 60chan#e Co++ission. C) Federal Board of 5rade. D) none of the above. Answer A 3-, 11) 5he purpose of the Co++odit) Futures 5radin# Co++ission is to do all of the followin# e0cept A) oversee futures tradin#. B) see that prices are not +anipulated. C) approve proposed futures contracts. D) establish +ini+u+ prices for futures contracts. Answer D 2-) 5he nu+ber of contracts outstandin# in a particular financial future is the A) de+and coefficient. B) open interest. C) inde0 level. D) outstandin# balance. Answer B

21) 5he futures +arkets have #rown rapidl) in recent )ears because A) interest rate volatilit) has increased. B) financial +ana#ers are +ore risk averse. C) both !A) and !B). D) neither !A) nor !B). Answer C 22) 5he advanta#e of forward contracts over future contracts is that forward contracts A) are standardi9ed. B) have lower default risk. C) are +ore li(uid. D) none of the above. Answer D 23) 5he advanta#e of forward contracts over futures contracts is that forward contracts A) are standardi9ed. B) have lower default risk. C) are +ore fle0ible. D) both !A) and !B) are true. Answer C 2') Futures +arkets have #rown rapidl) because futures A) are standardi9ed. B) have lower default risk. C) are li(uid. D) all of the above. Answer D 3-. 2*) Futures differ fro+ forwards because the) are A) used to hed#e portfolios. B) used to hed#e individual securities. C) used in both financial and forei#n e0chan#e +arkets. D) standardi9ed contracts. Answer D 2,) Futures differ fro+ forwards because the) are A) used to hed#e portfolios. B) used to hed#e individual securities. C) used in both financial and forei#n e0chan#e +arkets. D) +arked to +arket dail). Answer D 2.) "hich of the followin# features of futures contracts were not desi#ned to increase li(uidit)$ A) %tandardi9ed contracts. B) 5raded up until +aturit). C) 7ot tied to one specific t)pe of bond. D) Marked to +arket dail).

Answer D 2/) "hich of the followin# features of futures contracts were not desi#ned to increase li(uidit)$ A) %tandardi9ed contracts. B) 5raded up until +aturit). C) 7ot tied to one specific t)pe of bond. D) Can be closed with off settin# trade. Answer D 21) "hen a financial institution hed#es the interest:rate risk for a specific asset3 the hed#e is called a A) +acro hed#e. B) +icro hed#e. C) cross hed#e. D) futures hed#e. Answer B 3-) "hen the financial institution is hed#in# interest:rate risk on its overall portfolio3 then the hed#e is a A) +acro hed#e. B) +icro hed#e. C) cross hed#e. D) futures hed#e. Answer A 3-/ 31) 5he risk that occurs because stock prices fluctuate is called A) stock +arket risk. B) reinvest+ent risk. C) interest rate risk. D) default risk. Answer A 32) 5he +ost widel) traded stock inde0 future is on the A) Dow ;ones 1--- inde0. B) % < = *-- inde0. C) 7A%DA> inde0. D) Dow ;ones 3- inde0. Answer B 33) "ho would be +ost likel) to bu) a lon# stock inde0 future$ A) A +utual fund +ana#er who believes the +arket will rise B) A +utual fund +ana#er who believes the +arket will fall C) A +utual fund +ana#er who believes the +arket will be stable D) 7one of the above would be likel) to purchase a futures contract Answer A 3') 4f )ou bu) a futures contract on the %<= *-- 4nde0 at a price of '*- and the inde0 rises to *--3 )ou will A) lose 2123*--

B) #ain 2123*-C) lose 2*D) #ain 2*Answer B 3*) 4f )ou sell a futures contract on the %<= *-- 4nde0 at a price of '*- and the inde0 rises to *--3 )ou will A) lose 2123*-B) #ain 2123*-C) lose 2*D) #ain 2*Answer A 3,) "hich of the followin# is a likel) reason for a +one) +arket fund +ana#er to sell a stock inde0 future short$ A) ?e believes the +arket will rise. B) ?e wants to lock in current prices. C) ?e wants to reduce stock +arket risk. D) Both !B) and !C) are correct. Answer D 3-1 3.) 4f a +one) +ana#er believes stock prices will fall and knows that a block of funds will be received in the future3 then he should A) sell stock inde0 futures short. B) bu) stock inde0 futures lon#. C) sta) out of the futures +arket. D) borrow and bu) securities now. Answer A 3/) 4f a fir+ is due to be paid in euros in two +onths3 to hed#e a#ainst e0chan#e rate risk the fir+ should A) sell forei#n e0chan#e futures short. B) bu) forei#n e0chan#e futures lon#. C) sta) out of the e0chan#e futures +arket. D) do none of the above. Answer A 31) 4f a fir+ +ust pa) for #oods it has ordered with forei#n currenc)3 it can hed#e its forei#n e0chan#e rate risk b) A) sellin# forei#n e0chan#e futures short. B) bu)in# forei#n e0chan#e futures lon#. C) sta)in# out of the e0chan#e futures +arket. D) doin# none of the above. Answer B '-) &ptions are contracts that #ive the purchasers the A) option to bu) or sell an underl)in# asset. B) the obli#ation to bu) or sell an underl)in# asset.

C) the ri#ht to hold an underl)in# asset. D) the ri#ht to switch pa)+ent strea+s. Answer A '1) 5he price specified in an option contract at which the holder can bu) or sell the underl)in# asset is called the A) pre+iu+. B) call. C) strike price. D) put. Answer C '2) 5he price specified in an option contract at which the holder can bu) or sell the underl)in# asset is called the A) pre+iu+. B) strike price. C) e0ercise price. D) both !B) and !C) are true. Answer D 31'3) 5he seller of an option has the A) ri#ht to bu) or sell the underl)in# asset. B) the obli#ation to bu) or sell the underl)in# asset. C) abilit) to reduce transaction risk. D) ri#ht to e0chan#e one pa)+ent strea+ for another. Answer B '') 5he seller of an option has the @@@@@ to bu) or sell the underl)in# asset3 while the purchaser of an option has the @@@@@@@@@@ to bu) or sell the asset. A) obli#ationA ri#ht B) ri#htA obli#ation C) obli#ationA obli#ation D) ri#htA ri#ht Answer A '*) An option that can be e0ercised at an) ti+e up to +aturit) is called a!n) A) swap. B) stock option. C) 6uropean option. D) A+erican option. Answer D ',) An option that can be e0ercised onl) at +aturit) is called a!n) A) swap. B) stock option. C) 6uropean option. D) A+erican option. Answer C '.) &ptions on individual stocks are referred to as

A) stock options. B) futures options. C) A+erican options. D) individual options. Answer A '/) &ptions on futures contracts are referred to as A) stock options. B) futures options. C) A+erican options. D) individual options. Answer B 311 '1) 5he a#enc) which re#ulates stock options is the A) %ecurities and 60chan#e Co++ission. B) Co++odities Futures 5radin# Co++ission. C) Federal 5rade Co++ission. D) Both !A) and !B) are true. Answer A *-) 5he a#enc) which re#ulates future options is the A) %ecurities and 60chan#e Co++ission. B) Co++odities Futures 5radin# Co++ission. C) Federal 5rade Co++ission. D) Both !A) and !B) are true. Answer B *1) An option that #ives the owner the ri#ht to bu) a financial instru+ent at the e0ercise price within a specified period of ti+e is a!n) A) call option. B) put option. C) A+erican option. D) 6uropean option. Answer A *2) An option that #ives the owner the ri#ht to sell a financial instru+ent at the e0ercise price within a specified period of ti+e is a!n) A) call option. B) put option. C) A+erican option. D) 6uropean option. Answer B *3) A call option #ives the owner A) the ri#ht to sell the underl)in# securit). B) the obli#ation to sell the underl)in# securit). C) the ri#ht to bu) the underl)in# securit).

D) the obli#ation to bu) the underl)in# securit). Answer C *') A put option #ives the owner A) the ri#ht to sell the underl)in# securit). B) the obli#ation to sell the underl)in# securit). C) the ri#ht to bu) the underl)in# securit). D) the obli#ation to bu) the underl)in# securit). Answer A 312 **) A call option #ives the seller A) the ri#ht to sell the underl)in# securit). B) the obli#ation to sell the underl)in# securit). C) the ri#ht to bu) the underl)in# securit). D) the obli#ation to bu) the underl)in# securit). Answer B *,) A put option #ives the seller A) the ri#ht to sell the underl)in# securit). B) the obli#ation to sell the underl)in# securit). C) the ri#ht to bu) the underl)in# securit). D) the obli#ation to bu) the underl)in# securit). Answer D *.) 4f )ou bu) an option to bu) treasur) futures at 11*3 and at e0piration the +arket price is 11-3 A) the call will be e0ercised. B) the put will be e0ercised. C) the call will not be e0ercised. D) the put will not be e0ercised. Answer C */) 4f )ou bu) an option to sell treasur) futures at 11*3 and at e0piration the +arket price is 11-3 A) the call will be e0ercised. B) the put will be e0ercised. C) the call will not be e0ercised. D) the put will not be e0ercised. Answer B *1) 4f )ou bu) an option to bu) treasur) futures at 11-3 and at e0piration the +arket price is 11*3 A) the call will be e0ercised. B) the put will be e0ercised. C) the call will not be e0ercised. D) the put will not be e0ercised. Answer A ,-) 4f )ou bu) an option to sell treasur) futures at 11-3 and at e0piration the +arket price is 11*3

A) the call will be e0ercised. B) the put will be e0ercised. C) the call will not be e0ercised. D) the put will not be e0ercised. Answer D 313 ,1) 5he +ain advanta#e of usin# options on futures contracts rather than the futures contracts the+selves is that A) interest rate risk is controlled while preservin# the possibilit) of #ains. B) interest rate risk is controlled3 while re+ovin# the possibilit) of losses. C) interest rate risk is not controlled3 but the possibilit) of #ains is preserved. D) interest rate risk is not controlled3 but the possibilit) of #ains is lost. Answer A ,2) 5he +ain reason to bu) an option on a futures contract rather than bu)in# the futures contract is A) to reduce transaction cost. B) to preserve the possibilit) for #ains. C) to li+it losses. D) to re+ove the possibilit) for #ains. Answer B ,3) 5he +ain disadvanta#e of futures contracts as co+pared to options on futures contracts is that futures A) re+ove the possibilit) of #ains. B) increase the transactions cost. C) are not as effective a hed#e. D) do not re+ove the possibilit) of losses. Answer A ,') All other thin#s held constant3 pre+iu+s on put options will increase when the A) e0ercise price increases. B) volatilit) of the underl)in# asset falls. C) ter+ to +aturit) increases. D) !A) and !C) are both true. Answer C ,*) All other thin#s held constant3 pre+iu+s on call options will increase when the A) e0ercise price falls. B) volatilit) of the underl)in# asset falls. C) ter+ to +aturit) decreases. D) futures price increases. Answer A ,,) All other thin#s held constant3 pre+iu+s on both put and call options will increase when the A) e0ercise price increases. B) volatilit) of the underl)in# asset increases. C) ter+ to +aturit) decreases.

D) futures price increases. Answer B 31' ,.) An increase in the volatilit) of the underl)in# asset3 all other thin#s held constant3 will @@@@@ the option pre+iu+. A) increase B) decrease C) increase or decrease D) 7ot enou#h infor+ation is #iven. Answer A ,/) An increase in the e0ercise price3 all other thin#s held constant3 will @@@@@ the pre+iu+ on call options. A) increase B) decrease C) increase or decrease D) 7ot enou#h infor+ation is #iven. Answer B ,1) 4f a bank +ana#er wants to protect the bank a#ainst losses that would be incurred on its portfolio of treasur) securities should interest rates rise3 he could A) bu) put options on financial futures. B) bu) call options on financial futures. C) sell put options on financial futures. D) sell call options on financial futures. Answer A .-) A financial contract that obli#ates one part) to e0chan#e a set of pa)+ents it owns for another set of pa)+ents owned b) another part) is called a A) cross hed#e. B) cross call option. C) cross put option. D) swap. Answer D .1) A swap that involves the e0chan#e of a set of pa)+ents in one currenc) for a set of pa)+ents in another currenc) is a!n) A) interest rate swap. B) currenc) swap. C) swapation. D) national swap. Answer B .2) A swap that involves the e0chan#e of one set of interest pa)+ents for another set of interest pa)+ents is called a!n) A) interest rate swap.

B) currenc) swap. C) swapation. D) national swap. Answer A 31* .3) 4f %econd 7ational Bank has +ore rate:sensitive assets than rate sensitive liabilities3 it can reduce interest rate risk with a swap which re(uires %econd 7ational to A) pa) a fi0ed rate while receivin# a floatin# rate. B) receive a fi0ed rate while pa)in# a floatin# rate. C) both receive and pa) a fi0ed rate. D) both receive and pa) a floatin# rate. Answer B .') 4f %econd 7ational Bank has +ore rate:sensitive liabilities then rate:sensitive assets3 it can reduce interest rate risk with a swap which re(uires %econd 7ational to A) pa) a fi0ed rate while receivin# a floatin# rate. B) receive a fi0ed rate while pa)in# a floatin# rate. C) both receive and pa) a fi0ed rate. D) both receive and pa) a floatin# rate. Answer A .*) 4f a bank has a #ap of :21- +illion3 it can reduce its interest rate risk b) A) pa)in# a fi0ed rate on 21- +illion and receivin# a floatin# rate on 21- +illion. B) pa)in# a floatin# rate on 21- +illion and receivin# a fi0ed rate on 21- +illion. C) sellin# 22- +illion fi0ed rate assets. D) bu)in# 22- +illion fi0ed rate assets. Answer A .,) &ne advanta#e of usin# swaps to eli+inate interest:rate risk is that swaps A) are less costl) than futures. B) are less costl) than rearran#in# balance sheets. C) are +ore li(uid than futures. D) have better accountin# treat+ent than options. Answer B ..) 5he disadvanta#e of swaps is that A) the) lack li(uidit). B) it is difficult to arran#e for a counterpart). C) the) suffer fro+ default risk. D) all of the above. Answer D ./) As co+pared to a default on the notional principle3 a default on a swap A) is +ore costl). B) is about as costl). C) is less costl). D) +a) cost +ore or less than default on the notional principle.

Answer C 31, .1) 4nter+ediaries are active in the swap +arkets because A) the) increase li(uidit). B) the) reduce default risk. C) the) reduce search cost. D) all of the above are true. Answer D /-) A valid concern about financial derivatives is that A) the) allow financial institutions to increase their levera#e. B) the) are too sophisticated because the) are so co+plicated. C) the notional a+ounts can #reatl) e0ceed a financial institutionBs capital. D) all of the above are valid concerns. 6) none of the above is a valid concern. Answer A /1) 5he bi##est dan#er of financial derivatives A) occurs when notional a+ounts e0ceed a bankBs capital. B) occurs when financial +arket prices and rates are hi#hl) volatile. C) occurs in tradin# activities of financial institutions. D) occurs in the lar#e a+ount of credit e0posure. Answer C

23.2 5rueCFalse
1) 4f a bank has +ore rate:sensitive liabilities than assets3 a rise in interest rates will reduce bank profits3 and a decline in interest rates will raise bank profits. Answer 5DE6 2) Credit rationin# occurs when lenders refuse to +ake loans even thou#h borrowers are willin# to pa) +ore than the stated interest rate. Answer 5DE6 3) A forward contract is +ore fle0ible than a futures contract. Answer 5DE6 ') Futures contracts are standardi9ed. Answer 5DE6 *) A lon# contract obli#ates the holder to sell securities in the future. Answer 5DE6 ,) A short contract obli#ates the holder to sell securities in the future. Answer 5DE6 31. .) &ne proble+ with a futures contract is findin# a counterpart). Answer 5DE6 /) Futures contracts are subFect to default risk. Answer 5DE6 1) Futures tradin# is re#ulated b) the Co++odit) Futures 5radin# Co++ission. Answer 5DE6 1-) &pen interest allows investors to chan#e the interest rate on futures contracts.

Answer 5DE6 11) 5o reduce the interest rate risk of holdin# a portfolio of securities3 futures contracts should be sold. Answer 5DE6 12) 5o reduce e0chan#e rate risk fro+ sellin# #oods to a forei#n countr)3 futures contracts should be sold. Answer 5DE6 13) An option that #ives the holder the ri#ht to bu) an asset in the future is a put. Answer FAG%6 1') &ption pre+iu+s increase as the ter+ to +aturit) increases. Answer 5DE6 1*) &ption pre+iu+s fall as the volatilit) of the underl)in# asset falls. Answer 5DE6 1,) Esin# options to control interest rate risk reduces the chance of a loss but increases the chance of a #ain. Answer FAG%6 1.) &ne advanta#e of usin# options to hed#e is that the accountin# transaction will never re(uire the fir+ to show lar#e unreco#ni9ed losses. Answer 5DE6 1/) 4nterest rate swaps involve the e0chan#e of a set of pa)+ents in one currenc) for a set of pa)+ents in another. Answer FAG%6 11) Currenc) swaps involve the e0chan#e of a set of pa)+ents on one currenc) for a set of pa)+ents in another. Answer 5DE6 2-) 4f Friendl) Finance Co+pan) has +ore interest rate sensitive assets than interest rate sensitive liabilities3 it +a) reduce risk with a swap. Answer 5DE6 31/ 21) 4nterest rate swaps are +ore li(uid than futures contracts. Answer FAG%6 22) 4nter+ediaries add value to the swap +arket b) reducin# default risk. Answer 5DE6

23.3 6ssa)
1) ?ow do the concepts of adverse selection and +oral ha9ard e0plain the credit risk +ana#e+ent principles that banks adopt$ 2) Distin#uish between forward and futures contracts. 3) "h) have the futures +arkets #rown so rapidl) in recent )ears$ ') 60plain how a short hed#e could be used to i++uni9e a treasur) portfolio a#ainst interest rate risk.

*) 60plain how a lon# hed#e could be used to protect a bank fro+ the risk that interest rates could rise before a loan is funded. ,) ?ow would a fir+ use e0chan#e rate futures to lock in current e0chan#e rates$ .) 60plain how a swap could be used to reduce interest rate risk for a bank with +ore rate: sensitive assets than rate:sensitive liabilities. /) Define and distin#uish between call options and put options. 1) 60plain how option contracts could be used to protect a#ainst losses in portfolio value that +a) occur as interest rates increase. 1-) 60plain the advanta#es of protectin# a#ainst interest rate risk usin# options rather than futures contracts. 11) Discuss the advanta#es of usin# swaps to protect a#ainst interest rate risk rather than restructurin# the balance sheet.