F420 Chapter 23 Futures, Swaps, and Risk Management

Determine the one-year arbitrage profit under the following conditions: US rates are 3%; German rates are 7%; spot exchange rate is $1.10/€; forward rate is $1.08/€. Borrow either $100 or €100 to begin the transaction. A. €2.09 B. $2.05 C. €9.09 D. $5.05

B. $2.05 Reason: 1) Borrow $100 and repay $103. 2) Convert $100 to €90.909. 3) Invest €90.909 at 7% to get a FV of €97.27. 4) Use forward contract to convert back to $105.05. Profit of $105.05-$103 = $2.05.

Which of the following is best described as a cross-hedge? A. A risk-free fixed income security investor uses Treasury futures contracts. B. A grapefruit farmer uses orange juice futures to hedge commodity price risk. C. A pension fund manager with a passively-managed index portfolio with a beta of 1.0 uses an S&P 500 Index futures contract.

B. A grapefruit farmer uses orange juice futures to hedge commodity price risk. Reason: The asset owned by the farmer is different than the underlying futures contract asset.

Which of the following swaps behaves most like an insurance contract? A. Foreign exchange swap B. Credit default swap C. Interest rate swap

B. Credit default swap Reason: In a CDS, the swap buyer pays a regular premium to the swap seller in return for a promise of payment if the bond defaults.

BBJ International is paying its bondholders LIBOR plus 125 basis points. BBJ is concerned that rates will rise so it enters which of the following swaps? A. Pay floating for fixed B. Pay fixed for floating

B. Pay fixed for floating Reason: BBJ will receive floating payments from the swap dealer and make fixed payments to the dealer.

Current interest rates are higher in Scotland than in Mexico. The spot exchange rate is Peso20/Pound. Which of the following is more likely to be the no-arbitrage futures price? A. Peso22/Pound B. Peso18/Pound

B. Peso18/Pound Reason: Countries with higher interest rates will have their currencies sell for discounts in the derivatives markets, such as the forward and futures markets.

A US-based exporting firm has estimated the following regression equation: Annual Earnings = α + β (Exchange Rate). The regression results show alpha to be 10 and beta to be 8. If the exchange rate is USD1.25/Euro, determine the expected annual earnings. A. $8.00 B. $80.00 C. $20.00 D. $16.40

C. $20.00 Reason: 10 + (1.25 times 8) = 20

Chris Waters manages a $100 million fixed income portfolio with a modified duration of 5. Waters predicts a 30 basis point increase in the next week and would most likely estimate the portfolio will be worth ______. A. $101,500,000 B. $106,000,000 C. $98,500,000 D. $94,000,000

C. $98,500,000 Reason: The portfolio will lose 1.5% (5 times 0.003).

When the interest rate parity equation does not hold and it is possible to earn profits without exchange-rate risk, there is said to be a(n) ______ interest arbitrage opportunity. A. uncovered B. naked C. covered D. equilibrium

C. covered

Select all that apply Which statements are true of forward markets for foreign exchange? A. They are an informal network of banks and brokers. B. Risk is lessened because a trader's counterparty is an exchange. C. Positions are marked to market to determine margin obligations. D. Their contracts are not standardized.

A. They are an informal network of banks and brokers. D. Their contracts are not standardized.

When replicating an index with a futures and bills portfolio, the amount held in futures is the desired stock investment divided by the ______ and the amount in T-bills equals the ______ of the futures price. A. multiplier; future value B. multiplier; present value C. product of the multiplier and the index; present value D. product of the multiplier and the index; future value

C. product of the multiplier and the index; present value

True or false: Cash settlement avoids the costs that would be incurred if the long trader had to purchase the stocks in the index and deliver them to the short position, and if the short position then had to sell the stocks for cash instead.

False Reason: Cash settlement avoids the costs that would be incurred if the short trader had to purchase the stocks in the index and deliver them to the long position, and if the long position then had to sell the stocks for cash instead.

______ ______ ______ have a tremendous appeal to fixed-income managers because these contracts allow managers to quickly, cheaply, and anonymously restructure the balance sheet.

Interest rate swaps

True or false: A reverse strategy involving a short sale of the commodity may be done as long as the short sale contract appropriately accounts for the storage costs.

True

The risk to an investor that the other side of a contract will not perform its contractual obligations is referred to as ______ risk.

counterparty

The ______ ______ ______ allows two counterparties to take positions on the credit risk of those firms.

credit default swap

The ______ ______ in the swap market is not as large as the magnitude of notiational principal as markets suggest because the loss is only the difference between values of the fixed-rate and floating-rate obligations, not the total value of the payments that the floating-rate payer was originally obligated to make

credit risk

Hedging a position in one asset using futures on another commodity is a(n) ______-hedge.

cross

An agreement to exchange stipulated amounts of one currency for another at one or more future dates is a(n) ______ ______ ______

foreign exchange swap

Contracting today for the future purchase or sale of foreign exchange occurs in the ______ market.

forward

The number of hedging vehicles such as futures contracts required to offset the risk of a particular unprotected position is the ______ ______.

hedge ratio

By ______ the ______, the portfolio manager can make stock picks without concern for the market exposure of those stocks.

hedging; market

The investment strategy that exploits divergences between the actual index futures price and its theoretically correct parity value is ______ ______.

index arbitrage

Whenever the actual futures price differs from its parity value, there is an opportunity for profit referred to as ______ ______.

index arbitrage

Exchange rates for the Japanese yen or Swiss franc are examples of a(n) ______ quote.

indirect

The spot-futures exchange rate relationship that prevails in well-functioning markets is given by the ______ ______ ______ theorem.

interest rate parity

The principal amount used to calculate swap payments is the ______ principal.

notional

The change in the value of a fixed-income asset resulting from a 1 basis point change in the asset's yield to maturity defines the ______ ______ of a ______ ______.

price value; basis point

The immediate (two-day) purchase or sale of foreign exchange occurs on the ______ market.

spot

The exchange of a series of cash flows proportional to a given interest rate for a corresponding series of cash flows proportional to a floating interest rate is a common interest rate ______

swap

A broad equity index has a current value of 700 while a futures price on the index is quoted at 722. If the index increases in value by 10% by the maturity date of the futures contract, determine the profit to the long futures position. A. $48.00 B. $92.20 C. $70.00 D. $24.20

A. $48.00 Reason: The index will be valued at 770 on the maturity date of the contract (1.10 times 700). The profit will be 770 - 722.

A $25 million fixed income portfolio has a $1.0 million price value of a basis point while the Treasury bond futures contract has a $2,500 price value of a basis point. This portfolio could be fully hedged using ______ futures contracts. A. 400 B. 1,000 C. 10,000 D. 25

A. 400 Reason: The hedge ratio is the ratio of price value of spot to futures basis points: ($1,000,000/$2,500).

Select all that apply Which statements are correct about the use of futures to replicate positions in broad market indexes? A. A bills-plus-futures portfolio can be used to generate a 100% stock strategy. B. More interest is earned on the T-bill position when holding a short futures position than is typically earned on the proceeds of short sales. C. A disadvantage is that index futures are settled by delivery of the securities that make up the index. D. Transactions costs are lower than buying and selling the index's securities.

A. A bills-plus-futures portfolio can be used to generate a 100% stock strategy. B. More interest is earned on the T-bill position when holding a short futures position than is typically earned on the proceeds of short sales. D. Transactions costs are lower than buying and selling the index's securities.

Determine if there is an arbitrage opportunity in the foreign exchange market between Germany and England if interest rates are 8% in Germany and 6% in England. Current spot rate is GBP2.00/EUR and the quoted forward rate is GBP1.963/EUR. A. An arbitrage opportunity does not exist. B. An arbitrage opportunity does exist.

A. An arbitrage opportunity does not exist. Reason: Since (1.06)/(1.08) times 2.00 = GBP1.9629/EUR, there is no arbitrage opportunity.

Which formula gives the fair futures price of a commodity? Define F0 as the futures price, P0 as the spot price, and c as the carrying costs as a percentage of the current price. A. F0 = P0 (1 + rf + c) B. F0 = P0 (1 + rf - c)-1 C. F0 = P0 (1 + rf - c) D. F0 = P0 (1 + rf + c)-1

A. F0 = P0 (1 + rf + c)

Select all that apply Which statements are true about the profits of a US firm exporting to the UK as illustrated in the graph? (Click to enlarge.) A. The firm's profits increase as the pound appreciates. B. The predicted linear relationship holds for each of the observed eight data points. C. Profits were $2 million when the exchange rate was $1.30/£. D. The linear relationship predicts that an increase in the exchange rate by $1/£ would increase profits by £2 million.

A. The firm's profits increase as the pound appreciates. C. Profits were $2 million when the exchange rate was $1.30/£.

Select all that apply Which statements are true of the price value of a basis point (PVBP)? A. When fully hedged, a fixed-income position has a PVBP of zero. B. The number of contracts necessary to hedge a portfolio is the ratio of the PVBP of a portfolio to the PVBP of the hedge vehicle. C. If two assets have different durations, they cannot have the same PVBP. D. The PVBP is typically employed in hedging equity index futures.

A. When fully hedged, a fixed-income position has a PVBP of zero. B. The number of contracts necessary to hedge a portfolio is the ratio of the PVBP of a portfolio to the PVBP of the hedge vehicle.

The currency futures markets employ ______ quotes. A. direct B. indirect

A. direct

Rock Financial has written a currency derivative contract in which the terms are standardized and which is traded on an organized exchange. The contract is most likely a ______. A. futures contract B. forward contract

A. futures contract

Select all that apply The profits from a firm's exports as measured in the firm's domestic currency are generally ______ when the domestic currency ______. A. lower; appreciates B. lower; depreciates C. higher; depreciates D. higher; appreciates

A. lower; appreciates C. higher; depreciates

Select all that apply When the unprotected portfolio position is ______ related to the value of an asset, the hedge strategy calls for a ______ position in that asset. A. positively; short B. negatively; long C. negatively; short D. positively; long

A. positively; short B. negatively; long

An investor believes the shares of HHY Inc are undervalued and wants a market neutral bet because she feels the broader market is overvalued. The determining factor in computing the accurate number of futures contracts to execute the hedge effectively is ______. A. the beta of HHY B. if HHY is contained in the index on which the futures contract is written C. the exchange on which the contract is traded

A. the beta of HHY Reason: Hedging strategies are based on the firm's measure of systematic risk, which is the firm's beta.

Select all that apply Which statements are true of the swap market? A. A party to a swap transaction typically only makes payments with a loss on the contract. B. The notional principal in the swap market is not a good description of the amount of its credit risk. C. At the time a swap transaction is initiated, it has zero net present value. D. The loss to the losing side of a swap is the notional value of the contract.

B. The notional principal in the swap market is not a good description of the amount of its credit risk. C. At the time a swap transaction is initiated, it has zero net present value.

Select all that apply Which statements are true of currency futures? A. Their contracts are not standardized. B. They trade on formal exchanges. C. No money changes hand until the delivery date. D. Counterparty risk is lessened by the clearinghouse being a party to both sides of transactions.

B. They trade on formal exchanges. D. Counterparty risk is lessened by the clearinghouse being a party to both sides of transactions.

A farmer uses futures contracts to hedge commodity price risk of his corn harvest. The farmer computes a hedge ratio of 219, which implies ______. A. the farmer has 219 days to harvest his corn to match the maturity date of the futures contract B. the farmer needs 219 corn futures contracts to hedge risk C. the most the farmer can lose in the futures market is $219

B. the farmer needs 219 corn futures contracts to hedge risk Reason: The hedge ratio is the number of futures contracts required to remove commodity price risk for this farmer.

Compute the futures price for the US dollar if US rates are 2%, Canadian rates are 5%, and the spot rate is 0.9USD/CAD. A. 0.857 USD/CAD B. 0.900 USD/CAD C. 0.918 USD/CAD D. 0.874 USD/CAD

D. 0.874 USD/CAD Reason: 0.9(1+.02)/(1+.05)

A bond portfolio is currently valued at $500,000. The portfolio would lose $3,000 in the event of a 10 basis point increase. The price value of a basis point is ______. A. $500 B. $5,000 C. $50,000 D. $30,000 E. $300 F. $3,000

E. $300 Reason: The PVBP is the ratio of the change in portfolio value over the basis point change (3000/10).

The euro-dollar exchange rate is an example of a(n) ______ quote.

direct

From the U.S. perspective, a(n) ______ quotation is the price of one unit of the foreign currency in U.S. dollars, and the amount of foreign currency needed to purchase $1 is a(n) ______ quotation.

direct; indirect

A strategy designed to exploit relative mispricing within a market, but which is hedged to avoid taking a stance on the direction of the broad market is said to be ______-______

market-neutral