Finance 4180: Exam 2 Flash Cards

One stock option gives the holder the right to buy or sell ______ shares of the underlying stock.

100

Fully amortizing option ARM's are usually available in _______ and _______ year maturities.

15 ; 30

The most common mortgage maturities are _______ and _______ year, with fixed interest payments

15 ; 30

in 2016, over _______ percent of all residential mortgages were sold or securitized

60

A(n) _______ gives the option holder the right to buy or sell the underlying asset at any time before and on the expiration date of the option.

American option

The major forward market participants are

Broker-dealers commercial banks investment banks

Duration provides a direct relationship between the _______ for a ______.

Change in security price; small change in interest rates

The largest options exchange is the

Chicago Board Options Exchange

Throughout the life of the bond, the _______ remains constant but the _______ may change due to the arrival of new information.

Coupon rate; required rate of return

The inverse relationship between interest rates and the present value of security holds for _______ and _______.

Current market prices; expected rates of return Fair present value; required rates of return

As interest rates increase, the price of a bond _______ at a(n) _______ rate.

Decreasing; decreasing

Alt-A mortgage borrowers are characterized by a lack of _______ and lower _______ than prime mortgage borrowers.

Documentation ; Credit Scores

T/F All else being equal, the higher the coupon rate, the lower the price of the bond

False

To insure certain types of mortgages against default risk, the government established the _______ and the _______ during the 1930's

Federal Housing Administration (FHA) ; Veterans' Administration (VA)

To encourage continued expansion in the housing market and to provide competition for Fannie Mae, the US government created ______ and ______ in the late 1960's

Freddie Mac (FHLMC) ; Ginnie Mae (GNMA)

_______ are standardized and traded on organized exchanges

Futures Contracts

A counterparty to a over-the-counter forward option contract is most likely to default when the counterpart is losing heavily on the contract and the FI is _______ on the contract.

In the money

As the rate of return on a bond _______, the duration _______.

Increases; Decreases Decreases; Increases

As the maturity of a bond _______, the duration ______, but at a(n) ______ rate.

Increases; increases; decreasing decreases; decreases; increasing

The relationship between the down payment, purchase price and the loan to value ratio (LTV) is given by

LTV = Loan amount / purchase price

The _______ the coupon on the bond, the _______ its duration.

Larger; Shorter Smaller; Longer

For large interest rate increases, duration _______ the fall in bond price.

Over predicts

When the required rate of return is equal the coupon rate, the bond will sell at

PAR

Duration relates the percentage change in bond _______ to _______ changes in interest rates.

Price; small

Derivative securities allow _______ to be transferred from those that want less to those that are willing to bear more.

Risk

For a call option, if the asset's market price is "S" and the strike price is "X", then the intrinsic value of an in the money call option is

S - X

The Wall Street Reform and Consumers Protection Act of 2010 would place regulation of OTC derivatives under the authority of the _______ and the _______.

SEC ; CFTC

The two primary regulators of derivatives trading in the U.S are the _______ and the _______.

SEC ; CFTC

Foreign currency futures contracts were introduced in response to the introduction of floating exchange rates between currencies of different countries following the

Smithsonian Agreements

A(n) _______ involves swapping an obligation to pay interest at a fixed or floating rate for payments representing the total return on a loan (interest and principal value changes).

Total return swap

True or False: GNMA only supports pools of mortgage loans whose credit risk is insured by one of four government agencies.

True

True or False: One of the important values of credit default swaps is that they allow FI's to maintain long-term customer lending relationships without bearing the full credit risk exposure from those relationships.

True

True or False: the experience of the financial crisis showed the financial world that credit default swaps are themselves subject to default risk.

True

True or false: an investor who has taken a position in an option can always liquidate that position by also taking the opposite side of that position, so the two positions net to zero

True

True or false: the collateral backing pass-through securities issued by private mortgage issuers does not meet the standards of a government-related issuer.

True

For a put option, if the asset's market price is "S" and the strike price is "X", then the intrinsic value of an in the money put option is

X - S

The return that the bondholder will earn on a bond if he or she buys it at its current market price, receives all coupon and principal payments as promised, and holds the bond to maturity is the

Yield to maturity

When the required rate of return is greater than the coupon rate, the bond will sell at

a discount

For an Interest Only ARM, once the initial interest-only period has ended, the borrower loses the interest-only payment option and the loan must convert to

a fully amortizing option ARM

For a Minimum Payment Option ARM, once the principal has reached 110 to 115 percent of the original loan balance, the borrower loses the minimum payment option and the loan must be convert to (choose all that apply)

a fully amortizing option ARM ; an interest Only Option ARM

A forward contract can be used as a _______ against the risk that future spot prices on an asset will move against the investor, by guaranteeing a future price for the asset today.

a hedge

When the required rate of return is less than the coupon rate, the bond will sell at

a premium

A mortgage whose interest rate is tied to some market interest rate or interest rate index is called a(n) _______ mortgage

adjustable rate

To boost their earnings in the risky subprime mortgage market and take advantage of low interest rates, mortgage lenders offered _______ mortgages with very low initial rates.

adjustable rate

If a piece of real estate is used to secure both a first and a second mortgage, the second mortgage holder is paid _______ the first mortgage is paid off.

after

A document listing every mortgage payment and the portion of interest and principal paid in each payment is called a(n)

amortization schedule

The cash flows from a coupon bond consists of a lump sum repayment of principal at maturity, plus

an annuity of fixed interest payments paid over the life of the bond

in 2006, two events occurred that acted as triggers for the financial crisis of 2008. They were:

an increase in interest rates by the Fed ; a decline in housing prices

An FI has fixed-rate liabilities in a foreign currency is exposed to the risk that the foreign currency may _______ against the FI's home currency, making interest and principal payments in the currency ______ expensive.

appreciate ; more

A(n) _______ in futures contracts seeks to take advantage of inefficiencies in the pricing of an asset between two markets by taking a long position in one market and a short position in the other market.

arbitrageur

Mortgages differ from most other types of debt securities (except mortgage bonds) in that mortgages

are backed by real property

As the market price "S" of the underlying asset increases. the put writer's potential gains

are limited to the put premium

Conventional mortgages _______ federally insured

are not

Exchange traded derivative securities _______ subject to risk-based capital requirements for banks, but over the counter derivative securities potentially ______.

are not ; are

Bond issuers usually set a bond's coupon rate close to the required rate of return at a time of issuance so the bond will initially sell

at PAR

With a forward contract, cash payments between buyer and seller occur _______, while futures contracts are _______.

at contract maturity ; marked to market daily

A mortgage for which only interest payments are required for period of years, followed by a single principal repayment is called a(n)

balloon payment mortgage

In an interest rate swap agreement, the party receiving or making the floating rate payments may be exposed to _______ if the index on which the payments are based does not closely track their floating rate asset or liability.

basis risk

The residual risk that arises because the prices of the assets or liabilities hedged are imperfectly correlated over time with the prices of the forward or futures contracts used to hedge is called

basis risk

In a forward rate agreement, the buyer is the _______ and the seller is the ______, unlike other types of debt securities.

borrower ; lender

Many FI's ________ rather than _______ options for regulatory reasons.

buy ; write

A derivative hedge solution to an interest rate risk exposure caused by a large positive duration gap is to go off the balance sheet and

buy an interest rate swap

The _______ of a call option on a bond is taking a _______ position in the call option.

buyer ; long

Buying a cap to hedge against rising interest rates is like _______ on interest rates.

buying a call

The payoff of a portfolio consisting of taking a long position on a bond and buying a put on that bond mimics the payoff of

buying a call option

An FI can hedge the interest rate risk exposure of a bond on the liability side of its balance sheet by

buying a call option on the bond

Buying a floor to hedge against falling interest rates is like _______ on interest rates.

buying a put

An FI can hedge the interest rate risk exposure of a bond on the asset side of the balance sheet by

buying a put option on the bond

A _______ gives the buyer the right but not the obligation to buy an underlying security at a prespecified price called the exercise or strike price.

call option

The buyer of a _______ on a future contract has the right to _______ the underlying futures contact on or before expiration of the option at the exercise price.

call option ; buy put option ; sell

Convexity is good because the _______ of large interest rate increases tends to be smaller than the ______ of large interest rate decreases

capital loss effect; capital gains effect

One difference between a stock option and a stock index option is that at expiration, the stock index option is always settled in

cash

In the event of a default, a credit default swap may be settled by a _______ or _______.

cash payment ; delivery of bonds

In the post-2008 era, swap markets have introduced _______ to act as the counterparty to both sides of a swap transaction and thus reduce risk to both buyers and sellers

central clearinghouses

Buyers and sellers of future contracts do not deal directly with each other, but rather with the exchange _______ who ensures that all trades are completed.

clearinghouse

The exchange _______ breaks up every option trade into a buy and sell transaction and takes the opposite side of each transaction, separating buyers from sellers and guaranteeing that the trades will be completed.

clearinghouse

As a bond approaches maturity, the _______ the bond's price is _______

closer; to face value

A _______ occurs when a firm takes a simultaneous position in a cap and a floor.

collar

A _______ occurs when an FI takes a simultaneous position in a cap and a floor.

collar

A mortgage backed bond uses mortgages not for their cash flows, but as ______ for the bondholders.

collateral

For mortgages, the property purchased with the loan serves as _______ backing the loan

collateral

Alt-A mortgages are not _______ mortgages, so they cannot be sold to Fannie Mae or Freddie Mac

conforming

The exact bond price/interest rate relationship is _______, while duration is _______

convex; linear

As part of its ______ relationship with large banks, a small bank may make a loan that is too large for its balance sheet and sell parts of that loan to large banks.

correspondent banking

By replacing risky assets (mortgage loans) with cash or lower-risk assets, a mortgage sale can reduce a financial institution's credit risk, liquidity risk and interest rate risk, as well as regulatory costs such as the

cost of reserve requirements ; cost of holding required capital

While Ginnie Mae only guarantees the timing of payments on pass-through securities issued by others, Fannie Mae _______ and _______ pass-through securities.

creates ; guarantees payment of

In recent years, the fastest growing types of swaps have been

credit default swaps

The third of the modern wave of derivative securities to trade starting in the 1990's and 2000's were

credit derivatives

A total return swap provides some protection from both ______ and _______.

credit risk ; interest rate risk

By removing _______ from the lending process, credit swaps may loosen the incentives of FI's to carefully perform each step in the lending process.

credit risk exposure

A(n) _______ is a call option whose payoff increases as the default risk premium on a specified benchmark bond of the borrower increases above some exercise spread.

credit spread call option

Private mortgage pass-through issuers issue ______ to raise funds to purchase pools of non-conforming mortgages from financial institutions, then issues _______ based on those mortgage pools, which it sells to outside investors

debt securities ; pass-through securities

Price sensitivity to interest rate changes increases with increasing maturity at a _______ rate.

decreasing

Futures contracts are NOT subject to _______ risk

default

With reserve annuity mortgage (RAM), the property is sold to retire the debt when the borrower

dies

A(n) _______ is an option that pays the buyer a stated amount in the case of a loan default

digital default option

In the 2000's, the open-outcry auction method of trading futures contracts was gradually replaced by

electronic trading platforms

Futures contracts are _______ contracts with _______ terms and conditions

exchange traded ; standardized

The CFTC has exclusive jurisdiction over all

exchange-traded derivative securities

If a call option is "in the money", the buyer of the can _______, buying the stock at _______ and selling it at the market price.

exercise the option ; the stroke price "X"

As interest rates _______, the payoff of a put option on a bond _______.

fall ; falls rise ; rises

With a reverse annuity mortgage (RAM), the ______ makes regular payments to the

financial institution; borrower

One of the risks of a fixed-fixed currency swap is that the ______ in the swap contract may favor one party over the other depending upon the current _______.

fixed exchange rate ; spot rate

When interest rates are low, borrowers prefer _______ mortgages and lenders prefer ______ mortgages.

fixed rate ; adjustable rate

In a _______, two parties agree to swap currencies based on a agreed-upon fixed exchange rate over a period of time.

fixed-fixed currency swap

The buyer of an interest rate swap makes _______ payments, and the seller makes _______ payments

fixed-rate ; floating-rate

A ______ is like a put option on interest rates, and is used to hedge against decreases in interest rates.

floor

The buyer of a floor receives a payment from the seller proportional to the amount that interest rates drop below a specified _______ at maturity.

floor rate

The first of the modern wave of the derivative securities to trade were

foreign currency futures

Financial futures market trading was introduced in Chicago in 1972 with the establishment of trading in

foreign exchange futures contracts

A contractual agreement between a buyer and a seller to exchange an asset for cash at a specified later date for a specified price is called a(n)

forward contract

If a bond portfolio manager expects interest rates to rise, he or she can use a _______ to _______ bonds at a future date at a price specified today to offset the capital loss on the bond portfolio.

forward contract ; sell

Conceptually, a swap is a succession of _______ contracts.

forward rate

A ________ hedge produces symmetric gains and losses with interest rate increases and decreases.

futures

Like a forward contract, a ________ is a contractual agreement between a buyer and seller at time 0 to exchange a prespecified asset for cash at some later date at a price set at time 0.

futures contract

The underlying asset on a futures option is a(n)

futures contract

Ginnie Mae is a government-owned enterprise, but Fannie Mae and Freddie Mac are publicly owned corporations referred to as

government-sponsored enterprises

An important advantage of FI's functioning as swap dealers is that they generally

guarantee swap payments over the life of the contract

Sub-prime mortgages have a ______ rate of default than prime mortgages and thus have _______ interest rates than prime mortgages.

higher ; higher

A holder of a futures contract can liquidate their position by

holding the futures contract expiration and settling ; liquidating the position before the futures contract expires

If the forward hedge on a bond portfolio reduced the net interest rate exposure to zero, we say it has _______ the portfolio against interest rate risk.

immunized

If the price of the underlying stock is less than the strike price "X", the put option is said to be

in the money

When interest rates _______, the market value of a portfolio of bonds _______.

increase ; decreases decrease ; increases

Spot transactions occur because the buyer of the asset believes its value will

increase in the immediate future

As the marker price "S" of the underlying asset decreases, the put buyer's potential profit _______ (increases/decreases) to a limit.

increases

Subprime mortgages are mortgage loans issued to

individuals with poor credit

Brokerage firms require that their customers initally post only a portion of their futures contacts, called a(n) _______, whenever they request a trade.

initial margin

Brokerage firms require that their customers initially post only a portion of their futures contracts, called a(n) ______, whenever they request a trade.

initial margin

The default risk on a swap involves the loss of _______ only, while the default risk on a loan involves loss of ______

interest ; interest and principal

Swaps help their users better manage risks, such as

interest rate risk credit risk foreign exchange risk

Two FI's that have opposing balance sheet and interest rate risk exposure are good candidates for a(n)

interest rate swap

A collar is used to hedge against

interest rate volatility

Unlike macrohedging, microhedging ignores the _______ that already exist on the balance sheet.

internal hedges

At expiration, an option's value is equal to its

intrinsic value

There exists a(n) _______ relationship between interest rates and the present value of a security.

inverse

Credit risk protection transfers risk from the FI that _______ to an FI that _______.

issues a loan ; bears the default risk on that loan

A mortgage whose principal exceeds the conventional mortgage conforming limit set by Fannie Mae and Freddie Mac is called a _______ mortgage

jumbo

Higher coupon bond return a _______ portion of the investor's required rate of return in the form of a coupon payments compared to lower coupon bonds.

larger

If the option never goes "in the money", the option holder can liquidate their position by

letting the option expire unexercised

As the market price "S" of the underlying asset decreases. the call writer's potential gains are

limited to the call premium

Two important characteristics of federally insured mortgage loans are

little or no down payment is required ; there is a maximum loan size limit

Swap and forward contracts can be written for _______, while futures and options are generally written for _______

long periods ; short periods

When an investor buys a futures contract, they are taking a

long position

When using a forward contract as a bond portfolio hedge against rising interest rates, the ______ on the bond portfolio is partially or completely offset by the ______ on the forward contract.

loss ; gain

A borrower is likely to refinance their mortgage when interest rates on new mortgages are _______ the rate of their current mortgage

lower than

The credit risk on a swap is _______ the credit risk on a loan of equivalent dollar size.

lower than

An FI is _______ when it employs derivative securities contracts to hedge the entire balance sheet duration gap.

macrohedging

The Financial Accounting Standards Board has since 2000 required that all firms reflect the _______ value of their derivative positions in their financial statements

mark to market

Similar to trading in the stock market, futures trades may be placed as _______ or _______.

market order ; limit orders

Similar to trading in the stock market, options trades may be placed as _______ or _______.

market order ; limit orders

Collateralized mortgage obligations (CMO) give investors greater control over the _______ of the mortgage-backed securities they buy

maturity

The farther the bond is from maturity, the _______ the price of the bond is to interest rate changes.

more sensitive

The monthly interest and principal payments on the mortgage pool underlying a pass-through security are collected by the _______ for a fee.

mortgage originator or third-party servicer

The type of mortgage-backed security in which a mortgage is used as collateral for a debt security is a(n)

mortgage-backed bond

The writing of _______ is considered to be especially risky by regulators.

naked options

A financial institution that finances short-term floating rate assets with medium-term fixed rate liabilities will experience a _______ duration gap.

negative

When on each swap payment date, one party makes a single payment to the other party for the net difference between the fixed and floating payments, it is referred to as

netting of payments

The relationship between bond price sensitivity and maturity is

not linear

In a forward rate agreement, at maturity the buyer receives (or makes) a payment based on the ______ and the ______.

notional principal; difference between the contract rate and the final market rate

One "discount point" paid up from equals _______ of the principal value of the mortgage.

one percent

Like futures trading, options trading on exchanges occurs using a(n) _______ method.

open outcry auction

Futures contract trading on exchanges has traditionally been conducted using an _______ method

open-outcry auction

Futures trading occurs on

organized exchanges

Swaps and forwards are ______ contracts which can be customized to the needs of the customer.

over the counter

Forward contracts are _______ contracts with _______ terms and conditions

over the counter (OTC) ; customized

Using a pure credit swap, if an FI lender's loan defaults, the counterparty will cover the default loss by making a payment equal to the _______ minus the _______ of the defaulted loan

par value ; secondary market value

A large bank may sell portions of its loans, called _______, to smaller banks

participations

The two major types of mortgage-backed securities that are created by securitizing mortgages are

pass-through securities ; collateralized mortgage obligations

Due to the possibility of increasing interest payments and the eventual conversion to a fully-amortizing loan, interest only option ARM's carry a great deal of

payment-shock risk

Pass-through mortgage backed securities are subject to _______, an issue which the collateralized mortgage obligation was designed to address

prepayment risk

The default risk of a future contract is less than the default risk of a forward contract for four reasons, which are

price movement limits daily marketing to market default guarantees by the exchange margin requirements

One of the major functions of Ginnie Mae (GNMA) is to sponsor the mortgage-backed security programs of

private industry issuers

In order for secondary mortgage market buyers to purchase a conventional mortgage with a loan-to-value ratio of greater than 80 percent, the borrower must have

private mortgage insurance

On futures exchanges, ______ perform a similar function as the designated market makers do in the stock exchanges.

professional traders

To stabilize financial markets following the 9/11 terrorist attacks, the Federal Reserve Bank

provided loans to non-bank FI's such as investment banks ; lowered interest rates

In a(n) _______, a lender sends periodic payments to a counterparty, who will make a payment to compensate the lender if the lender's loans default. If the loans do not default, the counterparty keeps the payments.

pure credit swap

The risk that mortgage borrowers will repay or refinance their mortgages early, thus removing their monthly payment cash flows from the underlying mortgage backed security, is called

repayment risk

An option is a contract that gives the holder the _______ but not the _______ to buy and sell an underlying asset at a prespecified price for a specified time period.

right ; obligation

As interest rates _______, the payoff of a call option on a bond _______.

rise ; falls fall ; rises

As interest rates _______, the potential for the writer of a put option on a bond to receive a positive payoff _______.

rise ; falls fall ; rises

When interest rates _______, the value of a Eurodollar futures contract _______.

rise ; falls fall ; rises

As interest rates _______, the potential for the writer of a call option on a bond to receive a positive payoff _______.

rise ; rises fall ; falls

The sale of a mortgage to an outside buyer who may, under certain circumstances, return the mortgage to the seller is called a(n)

sale with recourse

In an interest rate swap, the _______ agrees to make a number of _______ payments based on a rate and a notional principal.

seller; floating interest rate buyer; fixed interest rate

If an FI stands to lose on the balance sheet when interest rates rise, then the appropriate hedge is a _______ position in Eurodollar futures.

short

An agreement that involves the immediate and simultaneous exchange of cash for securities is called a

spot contract

An investor who thinks the stock market index will rise will buy a _______, and the investor who thinks the stock market index will fall will buy a

stock index call option; stock index put option

An option contract for which the underlying asset is the value of a major stock market index is a(n)

stock index option

Interest rates on Alt-A mortgages tend to be between the rates on _______ and _______ mortgages.

sub-prime ; prime

Rising interest rates and falling home prices triggered mortgage defaults primarily in the _______ mortgage market

subprime

Financial institutions will often function as _______, matching counterparties to a swap or even taking one side of the swap themselves.

swap dealers

Freddie Mac also conducts a program by which it _______ mortgage-backed securities with a thrift in exchange for original conforming mortgages

swaps

Repayment of federally insured mortgages is guaranteed by either _______ or _______.

the FHA ; the VA

Private mortgage pass-through securities must be registered with _______ and are _______ in a manner similar to corporate bonds.

the SEC ; rated by a ratings agency

Once attached to a title, a lien remains in place until

the loan is paid off

Netting of payments implies that the default exposure of the in-the-money party is limited to _______ rather than either the total fixed or floating payment itself.

the net payment

The transfer of default risk to the mortgage buyer loosens the incentive of _______ to carefully preform each of the steps of the lending process.

the originator

In the originate and sell banking model, the default risk of the mortgage loans is passed from _______ to _______

the originator ; the buyer

The writer of a put option sells the option to the put buyer for which the writer receives _______ from the buyer.

the put premium

The _______ of an option is associated with the probability that the intrinsic value of the option could increase between the option's purchase date and the option's expiration date.

time value

The reason that an out of the money option has value and trades on the option markets is due to its

time value

Another of the major functions of Ginnie Mae (GNMA) is to provide ______, guaranteeing the timely pass-through of interest and principal payments to the security holder.

timing insurance

A _______ is used to hedge against an unexpected change in the credit risk of a counterparty to a loan or bond.

total return swap

The Wall Street Reform and Consumer Protection Act of 2010 called for most OTC derivatives to be

traded on regulated exchanges

Collateralized mortgage backed securities provide investors with a guaranteed annual coupon and protection from prepayment risk by repackaging the mortgage pool cash flows into ______ which can be sold separately to investors.

tranches

For large interest rate decreases, duration _______ the increase in bond price

under predicts

As the market price "S" of the underlying asset increases. The call buyer's potential profit is

unlimited

A writer of a naked call option on a bond (does not own the bond) faces potentially _______ when interest rates fall.

unlimited losses

In the "originate and sell" model of mortgage markets, mortgage lenders originate loans and sell them _______, thus passing the long-term credit risk to the loan purchaser.

without recourse

As an option approaches its expiration date, its time value approaches

zero

The intrinsic value of any out of the money option is

zero