Chapter 11
Explain how forward and futures markets differ.
A forward contract is arranged between two parties for the specific amount needed. It is an off-the-exchange, negotiated contract tailored to the needs of the counterparties. A futures contract, traded on an exchange, is a standardized contract on a quantity of a commodity or financial security. The exchange is the counterparty for all buyers and sellers of futures contracts, requiring an initial margin payment and daily settlement. The forward contract has a chance of default, whereas the futures contract does not. With only a few standardized futures contracts traded, one can seldom get a perfect hedge with futures, whereas a forward contract can hedge a transaction to the penny. Finally futures contracts provide investors with liquidity that allows them to change their positions if desired and forwards do not. Many futures do not result in delivery of the underlying asset, but forwards do.
What determines whether a buyer or a seller of a derivative security is a hedger or a speculator?
A hedger has a position in an underlying asset or an intention to trade the asset in the future. The hedger will thus trade derivatives to offset the price risk in the "spot" market. That is, the hedger buys/sells so as to gain in the derivative securities if adverse price movements occur in the spot market.
A bank has longer duration assets than liabilities and is considering using an interest rate swap to reduce its interest rate risk. Describe how a change in interest rates would impact the bank's equity. Should the bank pay a variable rate of interest and receive a fixed interest rate in the swap or vice versa? Explain why.
Because the bank has longer duration assets than liabilities the bank's market value of equity would be reduced if interest rates increase because the value of the assets will fall by more than the value of the liabilities in this case. To offset this risk the bank should enter into a swap agreement to pay fixed and in exchange pay a variable rate of interest. If interest rates increase the bank's payments remain fixed but they will receive more from the swap counterparty. The extra income will help offset the drop in value of equity resulting from the interest impact on the bank's balance sheet.
A bank has invested in a portfolio of mortgage backed securities. To limit its credit risk it should also issue a credit default swap on the mortgage portfolio. (T/F)
F
A hedger with a long spot position should buy futures to reduce their risk. (T/F)
F
A non-standardized agreement that is negotiated between a buyer and seller to exchange an asset for cash at some future date, with the price set today is called a future agreement. (T/F)
F
A pension fund manager can protect his/her recent price gains by buying stock index futures contracts. (T/F)
F
A swap entails buying and selling a futures contract at the same time. (T/F)
F
At least one of two counterparties in a forward contract must be a speculator. (T/F)
F
Futures contracts eliminate risk to all participants. (T/F)
F
If you forecast that interest rates are likely to decrease over the next several years, you might sell a T-bond futures contract or buy an interest rate cap to take advantage of your expectations. (T/F)
F
Margin risk involves the chance that initial margin requirements will be increased once an investor buys the futures contract. (T/F)
F
Most forward market contracts are settled before delivery. (T/F)
F
Portfolio insurance with stock index futures is used to eliminate unsystematic risk from stock portfolios. (T/F)
F
Speculators are gamblers that provide no social value to the economy. (T/F)
F
The Chicago Board Options Exchange is the primary regulator of options contracts. (T/F)
F
The long financial futures hedger net loses when futures contracts are marked to market after an increase in the price of the underlying asset. (T/F)
F
A bank has made fixed rate loans funded with shorter term certificates of deposit. To reduce its interest rate risk the bank could sell short term interest rate futures. (T/F)
T
A bank has made mortgages funded with 1 year certificates of deposit. To reduce its interest rate risk the bank could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest. (T/F)
T
A call option writer will profit if the underlying stock's volatility decreases in value, all else equal. (T/F)
T
A depository institution can reduce the variability of its cost of funds by selling Eurodollar futures. (T/F)
T
A hedger who is contracted to buy a commodity in the future may wish to reduce their price risk by buying futures contracts on the commodity. (T/F)
T
A savings and loan with interest rate-sensitive liabilities and interest rate insensitive assets (i.e., a negative GAP) might swap future fixed rate interest payments to receive variable rate interest payments to reduce its risk. (T/F)
T
Basis risk is the risk that the price of futures contracts will not vary in exactly the same way as the price of the item being hedged. (T/F)
T
Cross-hedgers involve more basis risk than direct hedges. (T/F)
T
Futures markets involve more standardized contracts compared to forward markets. (T/F)
T
If a stock's price is $56 per share a call option with a $60 exercise price will cost less than an equivalent maturity put option with the same exercise price. (T/F)
T
If the option exercise price is greater than the current stock price, a call option is out-of- the-money but the put option is in-the-money. (T/F)
T
In general, writing calls is riskier than buying puts. (T/F)
T
Margin requirements relate to the amount of cash down payment or equity one must have deposited before participating in a futures trade. (T/F)
T
Options premiums vary directly with the maturity of the option. (T/F)
T
The open interest is the number of outstanding contracts that have not been offset. (T/F)
T
The price sensitivity rule assists the hedger by estimating the number of futures contracts to trade. (T/F)
T
The writer of a call option on stock benefits if the underlying stock price decrease or if the volatility of the stock's price decreases. (T/F)
T
Writing calls can generate potentially unlimited losses. (T/F)
T
What role does the SEC have in regulating options markets? How does it differ from the role of the CFTC?
The SEC regulates any options on individual stocks, including stock index options, based on its regulatory authority of equity markets. The Commodity Futures Trading Commission regulates options that settle with the delivery of a futures contract, even if that contract is eventually settled based on the value of a stock index.
Explain how a bank that has made fixed rate mortgages funded by deposits could use futures or options to hedge against the possibility that interest rates will rise.
The bank manager likely faces a negative funding GAP, which means that the bank's net interest margin or equity value would be hurt if interest rates were to increase. To hedge all or a part of its interest rate risk, the bank manager could sell T-Bill futures or buy puts on T-Bill futures. The sale of futures establishes a gain in the futures if interest rates rise, locking in the selling price for the futures, offsetting the decline in the bank's net interest margin (or equity value). If interest rates fall, the futures loss would offset the gain in the "spot" or by the improvement in the bank's net interest margin. Buying put options on T-Bill futures provides one-way insurance for the price of the premium paid for the put. If interest rates increase, futures prices fall and the put value increases. If interest rates fall, the puts are out of the money and are not used. The only cost is the premium paid for the puts.
Suppose a stock is priced at $100 currently. You are bullish on the stock and are considering buying May calls with an exercise price of $95 and $105 respectively. The call with an exercise price $95 is priced at $8.50 and the 105 call is quoted at $2.75. What should you consider in deciding which to purchase if you do not plan on exercising prior to maturity? What are the breakeven stock prices for the two calls?
The call with exercise price $95 is in the money and could be exercised right away, but the option holder would lose the ($8.50 -$5) = $3.50 time value of the call by exercising it. The stock has to move up to $108.50 before the call buyer recovers the purchase price. Buying the 105 call is cheaper; the quote is $2.75 per share because this is an out-of-the-money call. If you buy the call with exercise price $105, the stock price has to move up to $107.75 ($105 + $2.75) before you make a profit. You have a lower breakeven than with the more expensive in the money call. You can also lose much less with the out of the money call. The answer as to which is better depends on your projection of the size of movement of stock price, the underlying stock volatility, and your own risk-return tolerance.
A manager of a large stock portfolio has earned a respectable return by October, and would like to protect that return for the rest of the year using options. Describe the least risky way she could guarantee a certain portfolio return with trades in derivative securities.
The portfolio managed by the portfolio manager seems to be large and well diversified, so stock index futures (S&P 500) or options on stock index futures can be used to lock in the rate of return achieved so far this year. Buying put options on the S&P 500 stock index futures (with the value of the contracts approximately equal to the portfolio value) will establish a floor price for the portfolio and protect the return for the year for the price of the premium paid for the put contract. If stock prices fall, the manager's spot market positions will experience a loss, but the value of the put options will increase, offsetting the loss in the portfolio.
A European option is an option contract that allows the holder to a. exercise the option only on the expiration date. b. exercise the option on or before the expiration date. c. exercise the option before but not on the expiration date. d. exercise the option after the expiration date.
a
A bank with a high positive duration GAP wishing to hedge its interest rate risk might a. sell financial futures. b. purchase financial futures. c. sell puts on financial futures. d. buy calls on financial futures.
a
A financial institution wishing to avoid higher borrowing costs would be most likely to use: a. a short or selling hedge in futures. b. a long or buying hedge in futures. c. purchase a call option on futures contracts. d. sell a put option on futures contracts.
a
A small commercial bank with more rate sensitive assets than rate sensitive liabilities sells T-bill futures. The bank is a. speculating. b. hedging. c. neither hedging nor speculating. d. both hedging and speculating.
a
A(n) margin is deposited before entering into the futures contract; thereafter, the balance cannot fall below a(n) _______ margin. a. initial; maintenance b. initial; enforced c. net; seller's d. safe; double e. first; second
a
On the second Friday of March, the market closing price of Independence & Co. stock is $100. Its March options are about to expire. One of its puts is worth $10 and one of its calls is worth $5. The exercise price of the put must be _____ and the exercise price of the call must be _____. a. 110, 95 b. 105, 95 c. 90, 105 d. 105, 90
a
The number of futures contracts required to hedge a position must account for I. the size of the spot position in relation to the size of the futures position. II. the relative price volatility of the spot and futures instruments. III. the initial margin requirement on the contract. IV. the termination date of the contract. a. I and II only. b. I and III only. c. II and IV only. d. III and IV only.
a
Which of the following statement is false? a. Forward contracts do not have credit risk. b. Futures contracts are standardized; forward contracts are not. c. Futures markets' price changes are settled daily. d. Delivery is made in forward markets but often not in futures.
a
You manage a stock portfolio worth $3,000,000 that has a beta of 1.25. In order to completely hedge the portfolio, you decide to trade S&P 500 futures contracts. Each contract is worth $250 per index point. How many contracts do you need to buy or sell if the S&P 500 index is currently at 1,500? a. sell 10 contracts b. buy 10 contracts c. sell 8 contracts d. buy 8 contracts e. buy 20 contracts
a
A bank which hedges its future funding costs in the T-bill futures market is a. hedging perfectly. b. accepting some basis risk. c. speculating. d. accepting some default risk in the futures position.
b
A college endowment fund is committed to purchasing stock in 3 months when the next installment from its capital campaign is received. To reduce its price risk the fund could I. buy stock index put options II. buy stock index call options III. buy stock index futures IV. sell stock index futures a. I or III b. II or III c. I or IV d. II or IV
b
A portfolio manager is concerned that the expected drop in interest rates is going to lower the yield on the $1,000,000 of T-Bill she plans to buy in 3 months. She can best hedge this potential interest rate risk by a. taking a short position in 3-month T-bill futures. b. taking a long position in 3-month T-bill futures. c. selling a call option on 3-month T-bill futures. d. buying a put option on 3-month T-bill futures.
b
An agreement between a business and a large money center bank to sell 10 million dollars of T-Bills in sixty days at a price set today is called a a. a call option. b. a forward contract. c. a put option. d. a long futures position.
b
An insurance company can best preserve the right to invest funds which are coming to the company in the future at today's interest rates by a. selling calls on financial futures. b. buying calls on financial futures. c. buying financial futures. d. selling financial futures. e. taking no action.
b
An investor planning to buy IBM stock in 30 days who believes that IBM's price will be very volatile in the near future can best protect himself against price risk by a. selling an IBM put option that matures in 30 days b. buying an IBM call option that matures in 30 days c. selling an IBM call option that matures in 30 days d. buying an IBM put option that matures in 30 days e. selling IBM stock short
b
Daily changes in futures prices means one party (hedger or speculator) has gained while another lost money on the contract. How are the exchanges able to keep the "daily" loser in the contract and prevent default? a. by the threat of bankruptcy b. by daily margin calls if needed c. by loans d. by guarantees by third parties
b
The lowest amount of funds required to maintain a positions in a futures contract is called a(n) _______ margin. a. initial b. maintenance c. variation d. parity e. futures
b
The purchase of U.S. Treasury bonds for immediate delivery is a _______ market transaction. a. stock b. spot c. futures d. forward e. swap
b
The value of a call option _______ and the value of a put option with the same price and expiration date _______ when the spot price of an underlying increases. a. increases; increases b. increases; falls c. does not change; does not change d. falls; increases e. falls; falls
b
What action would the holder of a maturing call option take if an option which cost $300, had a strike price of $50, and the market value of the stock was $52? a. let the option expire unexercised b. exercise the option c. request that the $300 be returned d. exercise the right to extend the option
b
Which of the following is true about hedging using duration analysis? a. The institution may hedge its earnings and its net worth simultaneously. b. If market value weighted asset duration is greater than the liability counterpart, sell financial futures to "immunize." c. If market value weighted asset duration is greater than the liability counterpart, buy financial futures to "immunize." d. Maturity hedging provides the same outcomes as duration hedging.
b
You hedged a $2,000,000 portfolio of stocks that you manage by selling eight S&P 500 futures contracts at 1,450. Each contract is worth $250 per index point. Recently, your portfolio lost 4% of its value, while the S&P 500 index declined to 1,400. What is your total (spot plus futures) gain (loss)? a. $80,000 b. $20,000 c. ($20,000) d. (80,000) e. (180,000)
b
A bank that has promised to make a loan to a customer in 6 months might best hedge its interest rate risk by a. buying interest rate futures b. buying stock index futures c. selling interest rate futures d. selling stock index futures
c
A firm is bidding on a construction project in Brazil. The outcome of the bid will not be known for 3 months. The firm will be paid in Reals in 6 months if they win the bid. The best way for the firm to hedge this risk over the entire time period is to a. buy Real futures. b. sell the Real forward. c. buy put options on the Real. d. buy call options on the Real.
c
A five-member federal regulatory commission which serves as the primary regulator of the futures market is the a. Chicago Mercantile Exchange. b. Federal Commodity Futures Commission. c. Commodity Futures Trading Commission. d. Chicago Board of Trade.
c
A speculator sold one 10-year T-note futures contract for $100,000 of face value of T- notes at 99'04.5. He posted a $2,500 margin on his account. The contract's closing price at the end of the day is 98'24. What is the amount of funds on the speculator's account after marking-to-market? a. $2,500 b. $3,305 c. $2,891 d. $3,500 e. $2,109
c
All of the following are risks associated with futures contracts except a. margin risk. b. basis risk. c. default risk. d. market manipulation risk.
c
First National Bank recently purchased a T-bill futures contract to hedge a risk position at the bank. If the price of the futures contract is increasing, a. First National is "net gaining." b. First National is "net losing." c. First National is neither "net gaining" nor "net losing." d. First National's hedge is not working properly.
c
If a corporation wanted to guarantee its long-term costs of financing an investment project, it could best hedge its risk by a. selling T-bill futures for when the funds were needed. b. buying T-bill futures for when the funds were needed. c. selling T-bond futures for when the funds were needed. d. buying T-bond futures for when the funds were needed.
c
The forward price for an asset is a. equal to the face value of the asset. b. always higher than the current price of the asset. c. the price that makes the forward contract have zero net present value. d. adjusted downward to incorporate storage costs.
c
Unlike hedging with futures, hedging with options a. locks in a particular price or rate of return for a hedger. b. exposes a hedger to a risk of large losses. c. allows a hedger to benefit from the upside potential of his spot position. d. requires no up front investment.
c
What is the regulator that approves newly issued futures contracts? a. The Federal Reserve b. The SEC c. The CFTC d. The NYSE
c
Which is NOT a function of the CFTC? a. to approve new futures contracts b. to monitor enforcement of exchange rules c. to make sure traders maintain their margin level d. to investigate violations of futures trading laws
c
Which of the following statements is NOT true? a. A swap is like a forward contract in that it guarantees the exchange of two items of value at some future point in time. b. Only the net interest difference is swapped in an interest rate swap. c. Swaps involve no credit risk just like futures contracts. d. Many swaps are between fixed interest rate payments and variable interest rate payments.
c
Which of the following terms is associated with futures as opposed to options? a. exercise price b. premium c. marking-to-market d. American vs European
c
Which one of the following statements is true? a. Derivatives markets are used to eliminate risk from the financial system. b. Derivatives markets may be used to transfer risk from speculators to other speculators. c. Derivatives markets may be used to transfer risk from speculators to hedgers. d. Derivatives markets are used to transfer risk from exchanges to investors.
c
A farmer growing wheat is in wheat and may hedge by _ wheat futures. a. short; long b. short; selling c. long; buying d. long; selling
d
A hedger in the financial futures market a. usually buys futures contracts. b. usually sells futures contracts. c. either buys or sells so that underlying asset gains/losses are directly related to futures contract gains/losses. d. either buys or sells so that underlying asset gains/losses are inversely related to futures contract gains/losses.
d
A pension fund wishes to reduce the beta of its portfolio from 1.2 to 0.5. The portfolio's market value is $5 million and the quote for the futures price is 2200. The contract has a 250 multiplier. Rounded to the nearest whole number, how many contracts should the pension fund use and should they buy or sell the contracts? a. buy 9 contracts b. sell 9 contracts c. buy 6 contracts d. sell 6 contracts e. buy 2 contracts
d
A portfolio manager plans to buy three-month T-bills with the total face value of $1,000,000 in one month. The current price for three-month T-bills is $988,520. What is the fair forward price if the current effective annual risk-free rate over one month is 4%? a. $950,500 b. $985,236 c. $988,520 d. $991,815 e. $1,028,061
d
A speculator sells one 10-year T-note futures contract for $100,000 of face value of T- notes at 98'14. Three month later, the contract expires at 101'10.5. How much did the speculator gain (lose)? a. $2,965 b. ($2,965) c. $2,891 d. ($2,891) e. $328
d
In the following who will lose if the price of an underlying asset falls? a. the seller of a futures contract b. the buyer of a put c. the writer of a call d. the buyer of a futures contract
d
The number of futures contracts that a bank will need in order to fully hedge the bank's overall interest rate risk exposure and protect the bank's net worth depends upon: I. The difference in the durations of bank assets and liabilities. II. The duration of the underlying security named in the futures contract. III. The price of the futures contract. a. I only b. I and II only c. II and III only d. I, II and III
d
The value of a call option varies directly with I. the price volatility of the underlying asset. II. the time to expiration. III. the exercise price. IV. the level of interest rates. a. I and II b. II, III and IV c. III and IV d. I, II and IV e. I, II, III and IV
d
What is the relationship between spot market prices and forward market prices of a good or financial asset? a. Spot prices equal expected forward prices. b. Forward prices are always higher than spot prices. c. Spot prices are always higher than forward prices. d. Forward prices are closely related to expected future spot prices.
d
Which of the following is not a derivative security? a. a call option on a stock index b. a futures contract c. an interest rate swap d. a repurchase agreement
d
You speculated that the stock price of Cino. Co. will move toward a certain direction and decided to taken an option position of this stock to make profit. For that position, if the stock's price drops you will get a level gain no matter how much prices decrease. However, you could go bankrupt if the stock's price rises sufficiently. What is your option position? You have ____________. a. purchased a call option b. purchased a put option c. written a put option d. written a call option
d
You have a right, but not the obligation, to buy a security at a specific price on a specific date if you _______ on this security. a. bought a forward contract b. sold a futures contract c. bought a put option d. sold a call option e. bought a call option
e
