Chapter 14 and 16 Financial Markets

If Fabrizio Bank attempts to capitalize on the above information, its profit over the five-day period is

455,266.81 euros.

A ____ requires a premium above and beyond the price to be paid for the financial instrument.

B and C

The ____ allowed for the devaluation of the dollar in 1971.

Smithsonian Agreement

A common maturity of a credit default swap contract is:

five years

European-style stock options

none of the above

A ____ swap allows the party making floating-rate payments to terminate the swap prior to maturity.

putable

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?

$-3

Assume that a British pound put option has a premium of $.03 per unit, and an exercise price of $1.60. The present spot rate is $1.61. The expected future spot rate on the expiration date is $1.52. The option will be exercised on this date if at all. What is the expected per unit net gain (or loss) resulting from purchasing the put option?

$.05 gain

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)?

$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?

$1,000

A speculator buys a call option for $3, with an exercise price of $50. The stock is currently priced at $49, and rises to $55 on the expiration date. The speculator will exercise the option on the expiration date (if it is feasible to do so). What is the speculator's profit per unit?

$2

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 stock price at which the speculator would break even?

$26

A speculator purchased a call option with an exercise price of $31 for a premium of $4. The option was exercised a few days later when the stock price was $34. What was the return to the speculator?

-25 percent

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 $____.

-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?

-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?

20 percent

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 and B

If a corporation hedges payables with currency call options, it will ____ if the value of the foreign currency is ____ than the exercise price when the payables are due.

A and D

Speculators may be willing to write ____ options on foreign currencies they expect to ____ against the dollar.

A and D

____ are not foreign exchange derivatives.

All of the above are foreign exchange derivatives.

Beginning with an equilibrium situation, if European inflation suddenly ____ than U.S. inflation, this forced ____ pressure on the value of the euro.

B and C

The ____ is the most important exchange for trading options.

Chicago Board of Options Exchange (CBOE)

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.

Credit default swap

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

False

A forward swap allows an institution to lock in the terms of the arrangement today, and the swap period begins immediately.

False

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

False

An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified floor interest rate.

False

Interest rate swaps are rarely used by companies that issue bonds.

False

The most common proxy for the benchmark rate from which a floating-rate payment is determined is the prime rate.

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?

Firm B will send Firm A $20,000

In a swap arrangement, the most common index used for floating-rate payments would be the

LIBOR

____ forecasting is usually based on either the spot rate or the forward rate.

Market-based

Which of the following statements is incorrect?

Most financial institutions that anticipate that interest rate will move in an unfavorable direction to not hedge their positions.

Option trading is regulated by the

Securities and Exchange Commission.

____ of options can close out their positions at any time by ____ an identical option.

Sellers; purchasing

____ forecasting involves the use of historical exchange rate data to predict future values.

Technical

The supply and demand for a currency are influenced by all of the following, except

The supply and demand for a currency are affected by all of the above.

Which of the following is not an assumption underlying the Black-Scholes option-pricing model?

The world is risk-neutral.

Which of the following is not true with respect to market makers?

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

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

True

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

True

If a large bank that has taken numerous swap positions and guaranteed many other swap positions fails, there could be several defaults on swap payments.

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

In July 2005, China implemented a new system in which the yuan could float within narrow boundaries based on a set of major currencies.

True

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

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

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

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

Sovereign risk differs from credit risk because it is dependent on the financial status of the government rather than the counterparty itself.

True

Stock options can be used by speculators to benefit from their expectations and by financial institutions to reduce their risk.

True

The Smithsonian Agreement allowed for a devaluation of the dollar and for a widening of the boundaries within which currencies were allowed to fluctuate.

True

The following information refers to Fresno Bank and Champaign Bank

True

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

A system whereby exchange rates are market determined without boundaries but subject to government intervention is called

a dirty float

The typical purchaser of an interest rate cap is a financial institution that is ____ affected by ____ interest rates.

adversely; rising

Interest rate ____ are interest rate derivative instruments that are normally classified separately from interest rate swaps.

all of the above

Which of the following is not a reason for financial institutions to engage in interest rate swaps?

all of the above are reasons for financial institutions to engage in swaps

Currency futures contracts differ from forward contracts in that they

are standardized.

Financial institutions such as U.S. savings institutions and commercial banks traditionally had fewer interest rate-sensitive ____ than ____ and therefore were adversely affected by ____ interest rates.

assets; liabilities; increasing

____ risk prevents the interest rate swap from completely eliminating a financial institution's exposure to interest rate risk.

basis

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

basis risk

A ____ grants the owner the right to purchase a specified financial instrument for a specified price within a specified period of time.

call option

When the market price of the underlying security exceeds the exercise price, the

call option is in the money

A(n) ____ swap allows the party making fixed-rate payments to terminate the swap prior to maturity.

callable

____ serve as financial intermediaries in the foreign exchange market by buying or selling currencies to accommodate customers.

commercial banks

The act of capitalizing on the discrepancy between the forward rate premium and the interest rate differential called

covered interest arbitrage.

An arrangement which enables firms to exchange currencies at periodic intervals is called a

currency swap

The premium on an existing call option should ____ when there is a reduction in the expected short-term volatility of the stock price.

decline

The premium on an existing put option should ____ when the underlying stock price increases.

decline

If U.S. interest rates suddenly become much higher than European interest rates, the U.S. demand for euros would ____, and the supply of euros to be exchanged for dollars would ____, other factors held constant.

decrease; increase

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.

decrease; increase; downward

A(n) ____ allows the party making fixed payments to extend the swap period.

extendable

The option on a callable swap would most likely be exercised if interest rates

fall

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

false

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

false

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

false

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

false

Fundamental forecasting has been found to be consistently superior to the other forecasting techniques.

false

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

false

Speculators who anticipate a decline in interest rates may consider writing a call option on Treasury bond futures.

false

The forward rate premium is dictated by the inflation rate differential of the two currencies.

false

The indirect exchange rate specifies the value of the currency in U.S. dollars.

false

The primary purpose of interest rate swaps is to reduce exchange rate risk.

false

The results with covered call writing are better than without covered call writing when the stock performs poorly and better when the stock performs well.

false

If a firm negotiates a plain vanilla swap, it will provide ____ payments in exchange for ____ payments.

fixed-rate; floating-rate

A(n) ____ swap involves an exchange of interest payments over a swap period that does not begin until a specified future point in time.

forward

If a firm planning to hedge receivables is certain of the future direction a spot rate will move, and requires a tailor-made hedge in terms of amount and maturity date, it should use a

forward contract

In a(n) ____ exchange rate system, the foreign exchange market is totally free from government intervention.

freely floating

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

have to make a payment of $90,000.

The greater the volatility of the underlying stock, the ____ the call option premium and the ____ the put option premium.

higher; higher

The longer the time to maturity, the ____ the call option premium and the ____ the put option premium.

higher; higher

Assuming the same expiration date, an option with a ____ exercise price has a ____ call option premium and a ____ put option premium.

higher; lower; higher

The Bretton Woods Era was the era

in which governments maintained exchange rates within 1 percent of a specified rate.

When stock portfolio managers use dynamic asset allocation by purchasing call options on a stock index, they ____ their exposure to stock market conditions.

increase

If the demand for British pounds ____, the pound will ____, other things being equal.

increase; appreciate

If U.S. inflation suddenly becomes much higher than European 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.

increase; decline; upward

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.

increase; declining

A(n) ____ in the supply of euros for sale will cause the euro to ____.

increase; depreciate

Purchasing Power Parity suggests that the exchange rate will on average change by a percentage that reflects the ____ differential between two countries.

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.

inflow; receive

An equity swap involves the exchange of

interest payments for payments linked to the degree of change in a stock index.

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

it receives an up-front fee.

If the U.S. government imposed trade restrictions on U.S. imports, this would ____ the U.S. demand for foreign currencies, and would place ____ pressure on the values of foreign currencies (with respect to the dollar).

limit; downward

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

locational arbitrage.

The ____, the higher the call option premium, other things being equal.

longer the maturity of the option

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)

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

In a period when interest rates are expected to rise, ____ institutions will want a fixed-for-floating swap, and the fixed rate specified on interest rate swaps will be ____ under these conditions.

many; higher

____ execute transactions desired by investors and trade stock options for their own account.

market-makers

When a stock index option is exercised, the cash payment is equal to a specified dollar amount

multiplied by the difference between the index level and the exercise price.

Assume a financial institution that has rate-sensitive liabilities and rate-insensitive assets. If interest rates are expected to decline consistently, this institution would benefit by negotiating a(n)

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.

notional

A system whereby one currency is maintained within specified boundaries of another currency or unit of account is a

pegged system

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

purchase an interest rate cap

Which of the following is the least feasible strategy for a speculator who expects the Australian dollar to depreciate?

purchase call options on Australian dollars; at some point before the expiration date, exercise the call option and then sell the Australian dollars received in the spot market

Corporations involved in international business transactions can ____ to hedge future ____.

purchase currency put options; receivables

An interest rate collar represents the ____ of an interest rate cap and a simultaneous ____ of an interest rate floor.

purchase; sale

Speculators who anticipate a decline in interest rates may consider ____ a ____ option on Treasury bond futures.

purchasing; call

When the exercise price exceeds the market price of the underlying security, the

put option is in the money.

A(n) ____ swap provides the party making the floating-rate payments with a right to terminate the swap.

putable

When stock portfolio managers use dynamic asset allocation by writing call options on a stock index, they ____ their exposure to stock market conditions.

reduce

The option on a putable swap would most likely be exercised if interest rates

rise

A plain vanilla swap is especially beneficial when interest rates are expected to

rise consistently

The most likely users of plain vanilla swaps would be

savings institutions.

A firm is involved in an agreement in which it makes payments in periods when a market interest rate rises above an interest rate level specified in the agreement. This means that the firm has

sold an interest rate cap.

According to the text, any political aspects that prevent a counterparty on a swap from meeting its payment obligations represent

sovereign risk.

Long-term equity anticipations (LEAPS) represent

stock options with longer terms to expiration than the more traditional stock options.

Generally, a ____ home currency can ____ domestic economic growth.

strong; dampen

The advantage of a rate-capped interest rate swap (relative to a plain vanilla swap) to a party exchanging floating payments for fixed payments is that

there is a maximum limit set on the interest payments it will provide.

A country that pegs its currency does not have complete control over its local interest rates, as its interest rates must be aligned with the interest rates of the currency to which it is tied.

true

A speculator who expects a foreign currency to appreciate could purchase the currency forward and, when received, sell it in the spot market.

true

Put options are typically used to hedge

when portfolio managers are mainly concerned with a temporary decline in a stock's value.

In the Wall Street Journal, you observe that the British pound (£) is quoted for $1.67. The Australian dollar (A$) is quoted for $0.62. What is the value of the Australian dollar in British pounds?

£0.37