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
