Financial Institutions HW 5

____ risk prevents the interest rate swap from completely eliminating a financial institution's exposure to interest rate risk. a. Credit b. Basis c. Sovereign d. None of the above

Basis

The primary advantage of currency options over forward and futures contracts is that they provide a right rather than an obligation to purchase or sell a particular currency at a specified price within a given period. True False

True

Assume a pension fund purchased stock at $53. Call options at a $50 exercise price presently have a $4 premium per share. The pension fund sells a call option on the stock it owns. If the call option is exercised when the price of the stock is $56, what is the gain or loss per share to the pension fund (including its gain from holding the stock as well)? a. $1 gain b. $4 gain c. $0 d. $2 loss e. $6 loss

$1 gain

A speculator purchases a put option on Treasury bond futures with a September delivery date with a strike price of 85-00. The option has a premium of 2-00. Assume that the price of the futures contract decreases to 82-00 on the expiration date and the option is exercised at that point (if it is feasible). What is the net gain? a. $3,750.00 b. -$2,000.00 c. $3,000.00 d. $1,000.00 e. $1,968.75

$1,000.00

A speculator purchases a put option for a premium of $4, with an exercise price of $30. The stock is presently priced at $29, and rises to $32 before the expiration date. What is the maximum profit per unit to the speculator who owned the put option assuming he or she exercises the option at the ideal time? a. -$4 b. $3 c. $2 d. -$3 e. -$2

-$3

Milton Briedman, a speculator, expects interest rates to increase and purchases a put option on Treasury bond futures with an exercise price of 95-32. The premium paid for the put option is 2-36. Just prior to the expiration date, the price of the Treasury bond futures contract is valued at 93-22. Briedman exercises the option and closes out the position by purchasing an identical futures contract. Briedman's net gain from this speculative strategy is $____. a. -406.25 b. 4,718.75 c. -4,718.75 d. -812.50 e. none of the above

-406.25

The Bank of Moronto has negotiated a plain vanilla swap in which it will exchange fixed payments of 10 percent for floating payments equal to LIBOR plus 0.5 percent at the end of each of the next three years. In the first year, LIBOR is 8 percent; in the second year, 9 percent; in the third year, LIBOR is 7 percent. What is the total net payment the Bank of Moronto makes over the three-year period if the notional principal is $10 million? a. -600,000 b. 600,000 c. 450,000 d. -450,000 e. none of the above

-450,000

A speculator purchased a put option with an exercise price of $56 for a premium of $10. The option was exercised a few days later when the stock price was $44. What was the return to the speculator? a. 120 percent b. -100 percent c. -20 percent d. 20 percent

20 percent

Assume the following information. · Interest rate on borrowed euros is 5 percent annualized · Interest rate on dollars loaned out is 6 percent annualized · Spot rate for €0.83 per dollar (one € = $1.20) · Expected spot rate in five days is €0.85 per dollar · Alonso Bank can borrow €10 million What is the euro profit to Alonso Bank over the five-day period from shorting euros and going long on dollars? a. €200,311.11 b. €207,111.11 c. €201,555.56 d. none of the above

201,555.56

Assume an insurance company purchases a call option on an S&P 500 Index futures contract for a premium of 14, with an exercise price of 1800. The value of an S&P 500 futures contract is 250 times the index. If the index on the futures contract increases to 1830, what is the gain on the sale of the futures contract? a. $1,500 b. $7,500 c. $4,000 d. $15,000 e. $3,300

4000

Assume the following information. · Interest rate on borrowed euros is 5 percent annualized. · Interest rate on dollars loaned out is 6 percent annualized. · Spot rate is 1.10 euros per dollar (one euro = $0.909). · Expected spot rate in five days is 1.15 euros per dollar. · Fabrizio Bank can borrow 10 million euros. If Fabrizio Bank attempts to capitalize on the above information, its profit over the five-day period is a. 2,653,597.22 euros. b. 455,266.81 euros. c. 452,426.04 euros. d. none of the above

455,266.81

Exhibit 15-1 Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 9 percent, 12 percent, and 13 percent at the end of each of the next three years, respectively. Refer to Exhibit 15-1. The total payments received (or paid) by Lizard, including the initial fee, are $____. a. 500,000 b. -500,000 c. -1,500,000 d. 1,500,000 e. none of the above

500,000

According to interest rate parity, if the interest rate in a foreign country is ____ than in the home country, the forward rate of the foreign country will have a ____. a. higher; discount b. lower; premium c. higher; premium d. A and B

A and B

On an exchange, option trades can be executed a. by a floor broker. b. electronically. c. by a market maker. d. all of the above e. A and B only

All of the above.

A ____ requires a premium above and beyond the price to be paid for the financial instrument. a. futures contract b. call option c. put option d. B and C

B and C

Beginning with an equilibrium situation, if European inflation suddenly ____ than U.S. inflation, this forced ____ pressure on the value of the euro. a. becomes much higher; upward b. becomes much higher; downward c. becomes much less; upward d. becomes much less; downward e. B and C

B and C

A ____ grants the owner the right to purchase a specified financial instrument for a specified price within a specified period of time. a. put option b. purchase of a futures contract c. call option d. sale of a futures contract

Call Option

American-style stock options can be exercised only just before expiration. True False

False

An equity swap involves the exchange of interest payments for payments linked to the degree of change in a bond index. True False

False

Exchange rates usually change precisely as suggested by the purchasing power parity (PPP) theory. True False

False

Financial institutions rarely use the forward market. True False

False

Market makers can execute stock option transactions for customers and do not trade stock options for their own account. True False

False

Purchasing power parity suggests that the forward rate premium (or discount) should be about equal to the differential in interest rates between the countries of concern. True False

False

Firms A and B have entered into an interest rate swap. On the first payment date, Firm A owes Firm B 12 percent of $10 million, and Firm B owes Firm A 14 percent of $10 million. Most likely, this transaction will be settled in what manner? a. Firm A will send Firm B $120,000 and Firm B will send Firm A $140,000 b. Firm B will send Firm A $120,000 and Firm A will send Firm B $140,000 c. Firm A will send Firm B $20,000 d. Firm B will send Firm A $20,000 e. none of the above

Firm B will send firm A $20,000

A ____ swap involves an exchange of interest rate payments that does not begin until a specified future point in time. a. putable b. zero-coupon-for-floating c. forward d. plain vanilla e. seasoned vanilla

Forward

Hewitt Inc. has entered into an equity swap arrangement that allows it to swap a fixed interest rate of 8 percent in exchange for the rate of appreciation on the Dow Jones Industrial Average each year over a three-year period. The notional principal is $1 million. If the Dow depreciates by 1 percent, Hewitt will a. have to make a payment of $70,000. b. have to make a payment of $90,000. c. receive a payment of $70,000. d. receive a payment of $90,000. e. none of the above

Have to make a payment of $90,000

____ forecasting involves the use of historical exchange rate data to predict future values. a. Mixed b. Technical c. Fundamental d. Market-based

Technical

Which of the following statements is incorrect? a. Forward contracts are contracts typically negotiated with a commercial bank that allow the purchase or sale of a specified amount of a particular foreign currency at a specified exchange rate on a specified future date. b. Many of the commercial banks that offer foreign exchange on a spot basis also offer forward transactions for the widely traded currencies. c. Forward contracts can hedge a corporation's risk that a currency's value may appreciate over time. d. The forward market is located in New York City.

The forward market is located in New York City.

An increase in uncertainty results in a higher implied standard deviation for the stock, which means that the writer of an option requires a higher premium to compensate for the anticipated increase in the stock's volatility. True False

True

An interest rate collar involves the purchase of an interest rate cap and the simultaneously sale of an interest rate floor. True False

True

An option with a higher exercise price has a higher call option premium and a lower put option premium. True False

True

If the quoted cross rate between two foreign currencies is not aligned with the two corresponding exchange rates, investors can profit from triangular arbitrage. True False

True

Interest rate floors are commonly used to hedge against lower interest rates. True False

True

Put options are more typically used to hedge when portfolio managers are mainly concerned about a temporary decline in a stock's value. True False

True

Several call options are available for a given stock, and the risk-return potential will vary among them. True False

True

Some conditional options require a premium if the trigger is reached anytime up until the expiration date; others require a premium only if the exchange rate is beyond the trigger as of the expiration date. True False

True

The following information refers to Fresno Bank and Champaign Bank. Bid Rate on Euros Ask Rate on Euros Fresno Bank $1.002 $1.009 Champaign Bank $0.997 $1.000 Based on this information, locational arbitrage would be profitable. True False

True

When the exercise price exceeds the market price of the underlying security, the a. put option is in the money. b. put option is out of the money. c. call option is at the money. d. call option is in the money.

a put option is in the money

Which of the following is not a reason for financial institutions to engage in interest rate swaps? a. to reduce interest rate risk b. to act as an intermediary c. to act as a dealer in swaps d. all of the above are reasons for financial institutions to engage in swaps

all of the above

____ are not foreign exchange derivatives. a. Forward contracts b. Currency futures contracts c. Currency swaps d. Currency options e. All of the above are foreign exchange derivatives.

all of the above

Currency futures contracts differ from forward contracts in that they a. are not an obligation. b. are standardized. c. are an obligation. d. can specify any amount and maturity date.

are standardized

Assume a U.S. savings institution funds its fixed-rate mortgages by attracting short-term deposits. If it engages in an interest rate swap, but the index on the swap does not move in perfect tandem with its cost of deposits, this reflects a. sovereign risk. b. basis risk. c. credit risk. d. none of the above

basis risk

Sellers (writers) of call options can offset their position at any point in time by a. selling a put option on the same stock. b. buying identical call options. c. selling additional call options on the same stock. d. all of the above e. A and B

buying identical call options

A(n) ____ swap allows the party making fixed-rate payments to terminate the swap prior to maturity. a. forward b. putable c. callable d. extendable

callable

A(n) ____ swap provides the party making the floating-rate payments with a right to terminate the swap. a. callable b. extendable c. plain vanilla d. putable e. none of the above

callable

Which of the following is most likely to provide currency forward contracts to their customers? a. international mutual funds b. insurance companies c. commercial banks d. brokerage firms

commercial banks

In a ____, a buyer makes periodic payments to a seller in exchange for protection against the possible default of debt securities specified in the contract. a. credit default swap b. default option contract c. bankruptcy contract d. default futures contract

credit default swap

The premium on an existing call option should ____ when there is a reduction in the expected short-term volatility of the stock price. a. be negative b. decline c. increase d. be unaffected e. A and B

decline

The premium on an existing put option should ____ when the underlying stock price increases. a. be negative b. decline c. increase d. be unaffected e. A and B

decline

If European inflation suddenly becomes must higher than U.S. inflation, the U.S. demand for European goods will ____. In addition, the supply of euros to be sold for dollars will ____; both forces will place ____ pressure on the value of the euro. a. increase; decline; upward b. increase; decline; downward c. decrease; increase; upward d. decrease; increase; downward e. none of the above

decrease; increase; downward.

A(n) ____ allows the party making fixed payments to extend the swap period. a. callable b. putable c. forward d. extendable

extendable

The option on a callable swap would most likely be exercised if interest rates a. fall. b. remain constant. c. remain somewhat stable. d. rise.

fall

A call option is said to be at the money when the market price of the underlying security exceeds the exercise price. True False

false

A country that pegs its currency is still able to maintain complete control over its local interest rates. True False

false

A putable swap gives the party making the fixed-rate payments the right to terminate the swap. True False

false

An equity swap involves the exchange of dividend payments for payments linked to the degree of change in a stock index. True False

false

The longer a call option's time to maturity, the lower the call option premium, other things being equal. True False

false

The potential benefits from using foreign exchange derivatives are independent of the expected exchange rate movements. True False

false

The writer of a put option is obligated to provide the specified financial instrument at the price specified by the option contract if the owner exercises the option. True False

false

There is risk that a firm involved in an interest rate swap may not meet its payment obligations; this risk is called systemic risk. True False

false

Which of the following statements is incorrect? a. Some firms allowed their CEOs to backdate options that they were granted to an earlier period when the stock price was lower. b. Backdating is completely inconsistent with the idea of granting options to encourage managers to focus on maximizing the stock price. c. Firms readily promote their option compensation programs and are more than willing to acknowledge that the options are an expense. d. All of the above are correct.

firms readily promote their option compensation programs and are more than willing to acknowledge that the options are an expense

The ____, the lower the premium on a put option, other things being equal. a. higher the existing price of the security relative to the exercise price b. greater the variability of the security's market value c. longer the maturity of the option d. A and B

higher the existing price of the security relative to the exercise price

Assuming the same expiration date, an option with a ____ exercise price has a ____ call option premium and a ____ put option premium. a. higher; higher; higher b. higher; higher; lower c. higher; lower; higher d. lower; lower; higher e. none of the above

higher; lower; higher.

The premium on an existing put option should ____ when there is an increase in the expected short-term volatility of the stock price. a. be negative b. decline c. increase d. be unaffected e. A and B

increase

If a U.S. institution in a forward swap would like to lock in the fixed rate that it will pay when the swap period begins, it is probably concerned that interest rates will ____; the counterparty is likely adversely affected by ____ interest rates. a. increase; increasing b. increase; declining c. decrease; declining d. decrease; increasing e. none of the above

increase; declining

A(n) ____ in the supply of euros for sale will cause the euro to ____. a. increase; appreciate b. increase; depreciate c. decrease; depreciate d. none of the above

increase; depreciate.

When a government influences factors, such as inflation, interest rates, or income, in order to affect currency's value, this is an example of a. a freely floating system. b. indirect intervention. c. direct intervention. d. a pegged system.

indirect intervention

Purchasing Power Parity suggests that the exchange rate will on average change by a percentage that reflects the ____ differential between two countries. a. tax b. income c. inflation d. interest rate

inflation

Assume a financial institution has rate-sensitive liabilities and rate-sensitive assets. If this institution negotiates a rate-capped swap, its ____ payments will be capped, and it will ____ an up-front premium in exchange for the cap. a. inflow; receive b. outflow; receive c. inflow; pay d. outflow; pay

inflow; receive

Buyers of credit default swaps are most likely going to receive a payment from the seller of credit default swaps when the economy: a. experiences high growth. b. experiences low inflation. c. is very weak. d. is stable.

is very weak

The advantage of a rate-capped interest rate swap to a party exchanging fixed payments for floating payments (relative to a plain vanilla swap) is that a. there is a minimum limit set on interest rate payments received. b. there is a maximum limit set on the interest payments it will provide. c. it receives an up-front fee. d. none of the above

it receives an up-front fee

AIG's financial problems were attributed to: a. its potential losses from its life insurance policies. b. fraud from avoiding taxes on its gains from credit default swaps. c. its weak returns on its investments in Treasury securities. d. its potential losses from credit default swaps.

it's potential losses from credit default swaps

Bank A asks $.555 for Swiss francs and Banks B and C are willing to pay $.557 for francs. An institution could capitalize on these differences by engaging in a. covered interest arbitrage. b. triangular arbitrage. c. witching hour arbitrage. d. locational arbitrage.

locational arbitrage

A savings and loan association has long-term fixed rate mortgages supported by short-term funds. A put option on Treasury bond futures could be used to (ignore the premium paid for the option when you answer this question) a. maintain its interest rate spread if interest rates fall, and increase its spread if interest rates rise. b. maintain its interest rate spread whether interest rates rise or fall. c. increase its interest rate spread whether interest rates rise or fall. d. maintain its interest rate spread if interest rates rise, and increase its spread if interest rates fall.

maintain its interest rate spread if interest rates rise, and increase its spread if interest rates fall

A savings and loan association has long-term fixed rate mortgages supported by short-term funds. A put option on Treasury bond futures could be used to (ignore the premium paid for the option when you answer this question) a. maintain its interest rate spread if interest rates fall, and increase its spread if interest rates rise. b. maintain its interest rate spread whether interest rates rise or fall. c. increase its interest rate spread whether interest rates rise or fall. d. maintain its interest rate spread if interest rates rise, and increase its spread if interest rates fall.

maintain its interest rate spread if interest rates rise, and increase its spread if interest rates fall.

A put option is "out of the money" when the a. market price of the security equals the exercise price. b. market price of the security is less than the exercise price. c. market price of the security exceeds the exercise price. d. premium on the option is less than the exercise price.

market price of the security exceeds the exercise price

A put option is "out of the money" when the a. market price of the security is less than the exercise price. b. market price of the security exceeds the exercise price. c. premium on the option is less than the exercise price. d. market price of the security equals the exercise price.

market price of the security exceeds the exercise price

European-style stock options a. are long-term options (at least one year until expiration at the time they are created). b. can be exercised after the expiration date. c. can be exercised any time until the expiration date. d. none of the above

none of the above

An interest rate swap agreement indicates the ____ value, which represents the principal amount to which interest rates are applied to determine the interest payments involved. a. programmed b. vanilla c. notional d. LIBOR

notional

An interest rate collar represents the ____ of an interest rate cap and a simultaneous ____ of an interest rate floor. a. sale; purchase b. purchase; sale c. purchase; purchase d. sale; sale

purchase; sale

A firm is involved in an agreement in which it receives payments in periods when a market interest rate rises above an interest rate level specified in the agreement. This means that the firm has a. purchased an interest rate cap. b. sold an interest rate floor. c. purchased an interest rate floor. d. sold an interest rate cap.

purchased an interest rate cap

The speculative risk of purchasing a ____ is that the foreign currency value ____ over time. a. futures contract; increases b. call option; increases c. put option; decreases d. put option; increases

put option; increases

The most likely users of plain vanilla swaps would be a. savings institutions. b. municipal governments. c. manufacturing companies. d. commercial banks that focus on short-term consumer loans.

savings institutions

____ of options can close out their positions at any time by ____ an identical option. a. Sellers; purchasing b. Sellers; selling c. Buyers; purchasing d. none of the above

sellers; purchasing

A firm is involved in an agreement in which it makes payments in periods when a market interest rate falls below an interest rate level specified in the agreement. This means that the firm has a. purchased an interest rate cap. b. sold an interest rate cap. c. purchased an interest rate floor. d. sold an interest rate floor.

sold an interest rate floor

Generally, a ____ home currency can ____ domestic economic growth. a. weak; dampen b. strong; stimulate c. strong; dampen d. A and B

strong; dampen

Which of the following is not a difference between purchasing an option and purchasing a futures contract? a. The option requires that a premium be paid in addition to the price of the financial instrument. b. Owners of options can choose to let the option expire on the so-called expiration date without exercising it. c. The fulfillment of futures contracts is regulated by exchanges, while the fulfillment of options is not. d. All of the above are differences between purchasing an option and purchasing a futures contract.

the fulfillment of futures contracts is regulated by exchanges, while the fulfillment of options is not

Which of the following is not true with respect to market makers? a. They benefit from the spread. b. They may earn profits when they take positions in options. c. They are not subject to the risk of loss on their positions in options. d. All of the above are true with respect to market makers.

they are not subject to the risk of loss on their positions in options

Central bank intervention can be overwhelmed by market forces and may not always succeed in reversing exchange rate movements. True False

true

When countries experience substantial net outflows of funds, they commonly use indirect intervention by raising interest rates to discourage excessive outflows of funds and therefore limit any downward pressure on the value of their currency. True False

true

Put options are typically used to hedge a. when portfolio managers are mainly concerned with a temporary decline in a stock's value. b. when portfolio managers are mainly concerned with a permanent decline in a stock's value. c. when portfolio managers are mainly concerned with a temporary increase in a stock's value. d. when portfolio managers are mainly concerned with a permanent increase in a stock's value.

when portfolio managers are mainly concerned with a temporary decline in a stocks value

In the Wall Street Journal, you observe that the British pound (£) is quoted for $1.65. The Australian dollar (A$) is quoted for $0.60. What is the value of the Australian dollar in British pounds? a. A$2.75 b. A$0.36 c. £2.75 d. £0.36 e. none of the above

£0.36