Chapter Seventeen
Contemporary Issues
Answers to Problems and Questions
1. The primary reason LTCM collapsed was the use of too much leverage and
the associated risk if security prices did not return to their historic
relationship. Shortly before the collapse the firm’s leverage ratio was over
100 to 1.
2. From the historical set of prices, you can calculate returns over the recent
past, and then determine the standard deviation of these returns. If you
calculate VAR using a 95% confidence interval and one day, you would
calculate the daily standard deviation, then form an interval 1.96 standard
deviations above and below the current stock price.
3. The returns on the stock and the call option are obviously correlated. You
could follow the same procedure as in Problem 2 to find the stock values.
Then use Black-Scholes to find the theoretical call value at both the upper
and lower stock prices. Subtracting the call value from the stock value
gives the range of covered call “portfolio” values.
4. Individual response.
5. The university might enter into a contract that would provide a cash inflow
to the university of the heating degree days were above a certain level. An
unusually hot season would mean more air conditioning and greater electric
bills, so the payoff from the derivative would partially offset the higher
expense.
6. A collar is cheaper. The premium from the option you write will partially
offset the cost of the option you buy. There is a risk tradeoff, however, as
the collar provides limited protection.
7. See the box describing the E-Toy executive. Exercise of the options may
result in a tax liability. A subsequent decline in the value of the stock may
mean that the employee does not have the assets to pay the tax bill.
8. One party buys stock on behalf of another, usually because the second party
is unable to efficiently buy the stock themselves. One party receives
interest based on some benchmark rate. The two parties periodically settle
up the paper gains/losses on the stock.
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Chapter Seventeen. Contemporary Issues
9. FASB believes that the use of derivatives requires more disclosure and
more frequent valuation than has been the traditional practice. In particular,
FASB believes the market risk of derivatives is relevant information that
users of the financial statements should be able to discern.
10. There are three main concerns. Marking to market frequently may increase
earnings volatility; some derivative products are not conveniently valued,
meaning there may be substantial subjectivity in the process; and there is
already evidence that some firms no longer use derivatives for risk
reduction because the new accounting rules are too onerous.
11. Individual response.
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