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CHAPTER 6: BASIC OPTION STRATEGIES
MULTIPLE CHOICE TEST QUESTIONS
Consider a stock priced at $30 with a standard deviation of 0.3. The risk-free rate is 0.05. There are
put and call options available at exercise prices of 30 and a time to expiration of six months. The
calls are priced at $2.89 and the puts cost $2.15. There are no dividends on the stock and the
options are European. Assume that all transactions consist of 100 shares or one contract (100
options). Use this information to answer questions 1 through 10.
1.
$37?
a.
b.
c.
d.
e.
What is your profit if you buy a call, hold it to expiration and the stock price at expiration is
$700
–$289
$2,711
$411
none of the above
2.
a.
b.
c.
d.
e.
What is the breakeven stock price at expiration on the transaction described in problem 1?
$32.89
$30.00
$27.11
$32.15
there is no breakeven
3.
a.
b.
c.
d.
e.
What is the maximum profit on the transaction described in problem 1?
$2,711
infinity
zero
$3,289
$3,000
4.
a.
b.
c.
d.
e.
What is the maximum profit that the writer of a call can make?
$2,711
$289
$3,000
$3,289
none of the above
5.
Suppose the buyer of the call in problem 1 sold the call two months before expiration when
the stock price was $33. How much profit would the buyer make?
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a.
b.
c.
d.
e.
$32.89
$30.11
$78.00
$11.00
none of the above
6.
Suppose the investor constructed a covered call. At expiration the stock price is $27. What
is the investor's profit?
a.
$589
b.
$289
c.
$2,989
d.
$2,711
e.
none of the above
7.
a.
b.
c.
d
e.
What is the breakeven stock price at expiration for the transaction described in problem 6?
$27.11
$30.00
$32.89
$29.89
none of the above
8.
If the transaction described in problem 6 is closed out when the option has three months to
go and the stock price is at $36, what is the investor's profit?
a.
$600
b.
$311
c.
$889
d.
$229
e.
none of the above
9.
What is the maximum profit from the transaction described in Question 6 if the position is
held to expiration?
a.
$3,289
b.
$289
c.
infinity
d.
$2,711
e.
none of the above
10.
What is the minimum profit from the transaction described in Question 6 if the position is
held to expiration?
a.
–$2,711
b.
–$3,289
c.
–$3,000
d.
negative infinity
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e.
none of the above
11.
Consider two put options differing only by exercise price. The one with the higher exercise
price has
a.
the lower breakeven and lower profit potential
b.
the lower breakeven and greater profit potential
c.
the higher breakeven and greater profit potential
d.
the higher breakeven and lower profit potential
e.
the greater premium and lower profit potential
12.
Which of the following statements is true about closing a long call position prior to
expiration relative to holding it to expiration?
a.
the profit is greater at all stock prices
b.
the profit is greater only at low stock prices
c.
the profit is greater only at high stock prices
d.
the range of possible profits is greater
e.
none of the above are true
13.
a.
b.
c.
d.
e.
Which of the following transactions does not profit in a strong bull market.
a short put
a covered call
a protective put
a synthetic call
none of the above
14.
a.
b.
c.
d.
e.
Which of the following is equivalent to a synthetic call?
a long stock and a short put position
a long put and a long stock position
a long put and a short risk-free bond position
a long stock and a short risk-free bond position
none of the above
15.
a.
b.
c.
d.
e.
Early exercise imposes a risk to all but one of the following transactions.
a short call
a short put
a protective put
an uncovered call
none of the above
16.
a.
b.
c.
Each of the following is a bullish strategy except
a long call
a short put
a short stock
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d.
e.
a protective put
none of the above
17.
a.
b.
c.
d.
e.
Which of the following strategies has the greatest potential loss?
an uncovered call
a long put
a covered call
a long position in the stock
it is impossible to tell
18.
a.
b.
c.
d.
e.
Which of the following strategies has essentially the same profit diagram as a covered call?
a long put
a short put
a protective put
a long call
none of the above
19.
Which of the following statements is true about the purchase of a protective put at a higher
exercise price relative to a lower exercise price?
a.
the breakeven is lower
b.
the maximum loss is greater
c.
the insurance is less costly
d.
the insurance is more costly
e.
none of the above
20.
a.
b.
c.
d.
e.
What is the disadvantage of a strategy of rolling over a covered call to avoid exercise?
the call premium is essentially thrown away
transaction costs tend to be high
the stock will incur losses
the call is more expensive when rolled over
none of the above
21.
a.
b.
c.
d.
e.
Which of the following is the breakeven for a protective put?
X + S0 – P
P + S0
X – ST
X – S0 – P
none of the above
22.
a.
b.
c.
Which of the following statements about a covered call writing strategy is true?
the losses are limited
return and risk are greater than that of simply holding the stock
it is a cheaper form of insurance than a protective put
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d.
e.
it generally makes a large number of small profits
none of the above
23.
a.
b.
c.
d.
e.
The difference in profit from an actual put and a synthetic put is
X
ST – X
X – ST
ST + X(1 + r)-T
none of the above
24.
a.
b.
c.
d.
e.
A covered call writer who prefers even less risk should
get rid of the call
switch to a call with a lower exercise price
get rid of the stock
switch to a call with a higher exercise price
none of the above
25.
a.
b.
c.
d.
e.
Which of the following investors may be obligated to buy stock?
covered call writer
call buyer
put writer
protective put buyer
none of the above
26.
Identify the correct statement related to the choice of exercise price for buying a call.
a.
the higher the exercise price the higher the call premium
b.
the lower the exercise price the more likely the call option will expire out-of-the-money
c.
A higher strike price results in smaller gains on the upside but smaller losses on the
downside
d.
the higher the exercise price the more dividends contribute to the overall profit
e.
none of the above are correct statements related to the choice of exercise price for buying a
call
27.
Consider the following statement related to writing a naked call option. For a given stock
price, the ____________ the position is held, the more time value it loses and the ___________ the
profit. Identify the correct words for these two blanks.
a.
longer, lower
b.
longer, higher
c.
shorter, lower
d.
shorter, higher
e.
longer, flatter
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28.
Consider the following statement related to buying a put option. For a given stock price, the
____________ the position is held, the more time value it loses and the ___________ the profit;
however, an exception can occur when the stock price is ___________. Identify the correct words
for these two blanks.
a.
longer, lower, low
b.
longer, higher, high
c.
shorter, lower, low
d.
shorter, higher, high
e.
longer, flatter, low
29.
A synthetic long call position can be created with which of the following sets of
transactions.
a.
borrow the present value of the strike price, sell stock, sell put
b.
lend the present value of the strike price, sell stock, buy put
c.
sell put, buy stock, lend the present value of the strike price
d.
buy stock, buy put, borrow the present value of the strike price
e.
none of the above creates a synthetic long call position
30.
A synthetic short put position can be created with which of the following sets of
transactions.
a.
borrow the present value of the strike price, sell stock, sell call
b.
lend the present value of the strike price, sell stock, buy call
c.
sell call, buy stock, lend the present value of the strike price
d.
buy stock, buy call, borrow the present value of the strike price
e.
none of the above creates a synthetic long call position
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CHAPTER 6: BASIC OPTION STRATEGIES
TRUE/FALSE TEST QUESTIONS
T
F
1.
The maximum loss on a call purchase is the premium on the call.
T
F
2.
Buying a put is the mirror image of buying a call.
T
F
3.
higher exercise price.
Buying a call with a lower exercise price offers a greater profit potential than one with a
T
F
possible.
To maximize profits on a call purchase, one should hold the position for as short a time as
4.
T
F
5.
Because of the greater time value, a call writer who closes the position prior to expiration
will always pay more for the call than if the position were held to expiration.
T
F
6.
A covered call writer will make a lower profit if the option is exercised early.
T
F
7.
The holder of a protective put has the equivalent of an insurance policy on the stock.
T
F
8.
only in a bear market.
A protective put can be profitable during a bull market, while a covered call is profitable
T
An investor can construct a synthetic put by buying a call and selling short a stock.
F
9.
T
F
10.
An advantage of using a put over a short sale is that the short sale requires an uptick or
zero-plus tick while a put does not.
T
F
expiration.
11.
The profit for a long put is higher for a given stock price if the put is sold back prior to
T
F
12.
a higher exercise price.
Given two bearish investors, the more risk averse investor would tend to select a put with
T
Both call and put writers have the potential for unlimited losses.
F
13.
T
F
14.
In the context of insurance, protective put buyers who choose lower exercise prices are
essentially using higher deductibles.
T
F
synthetic puts.
15.
As long as puts are available for trading, there is little justification for constructing
T
F
16.
Covered calls are a less costly way to protect stocks because you receive money for the
sale of the call, whereas you must pay money for a protective put.
T
F
17.
To reach breakeven on a call purchase held to expiration, the stock price must exceed the
exercise price by at least the amount of the call premium.
T
F
18.
A covered call provides protection for a stock price at expiration down to the current
stock price minus the premium.
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T
F
19.
Covered call writing should be considered a strategy to enhance the return on a stock.
T
F
20.
A protective put provides the same type of profit diagram as a long call.
T
F
21.
A covered call with a higher exercise price has a higher breakeven.
T
call.
F
22.
The profit from a covered call is the profit from a long stock plus the profit from a long
T
F
23.
A synthetic put is always less expensive than a synthetic call.
T
same.
F
24.
Any strategy consisting of only long options will lose money if the stock price stays the
T
F
25.
The breakeven for a protective put is the same as that for a covered call.
T
F
26.
The following is the profit equation for a put option: Π = NP[Max(0, X – ST) + P].
T
F
27.
If ST > X, then the profit for a call option can be expressed as: Π = ST – X – C.
T
F
28.
the option premium.
The break-even stock price equation is similar for both calls and puts, the strike price plus
T
F
29.
limited, potential loss.
Selling a put is a bullish strategy that has a limited gain (the premium) and a large, but
T
F
30.
A long put option position can be synthetically created by purchasing a call option, short
selling the stock, and purchasing a pure discount bond with face value equal to the strike price.
CHAPTER 7: ADVANCED OPTION STRATEGIES
MULTIPLE CHOICE TEST QUESTIONS
The following prices are available for call and put options on a stock priced at $50. The risk-free
rate is 6 percent and the volatility is 0.35. The March options have 90 days remaining and the
June options have 180 days remaining. The Black-Scholes model was used to obtain the prices.
Calls
Puts
Strike
March
June
March
June
45
6.84
8.41
1.18
2.09
50
3.82
5.58
3.08
4.13
55
1.89
3.54
6.08
6.93
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Use this information to answer questions 1 through 20. Assume that each transaction consists of
one contract (for 100 shares) unless otherwise indicated.
For questions 1 through 6, consider a bull money spread using the March 45/50 calls.
1.
a.
b.
c.
d.
e.
How much will the spread cost?
$986
$302
$283
$193
none of the above
2.
a.
b.
c.
d.
e.
What is the maximum profit on the spread?
$500
$802
$198
$302
none of the above
3.
a.
b.
c.
d.
e.
What is the maximum loss on the spread?
$500
$698
$198
$802
none of the above
4.
a.
b.
c.
d.
e.
What is the profit if the stock price at expiration is $47?
-$102
$398
-$302
$500
none of the above
5.
a.
b.
c.
d.
e.
What is the breakeven point?
$48.02
$41.98
$55.66
$50.00
none of the above
6.
Suppose you closed the spread 60 days later. What will be the profit if the stock price is
still at $50?
a.
$41
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b.
c.
d.
e.
$198
$302
$102
none of the above
For questions 7 and 8, suppose an investor expects the stock price to remain at about $50 and
decides to execute a butterfly spread using the June calls.
7.
a.
b.
c.
d.
e.
What will be the cost of the butterfly spread?
$1,195
$637
$79
$1,045
none of the above
8.
a.
b.
c.
d.
e.
What will be the profit if the stock price at expiration is $52.50?
$171
$1,421
$1.037
$421
none of the above
9.
Suppose you wish to construct a ratio spread using the March and June 50 calls. You want
to buy 100 June 50 call contracts. How many March 50 calls would you sell?
a.
105
b.
95
c.
100
d.
57
e.
none of the above
Answer questions 10 and 11 about a calendar spread based on the assumption that stock prices
are expected to remain fairly constant. Use the June/March 50 call spread. Assume one contract
of each.
10.
a.
b.
c.
d.
e.
What will the spread cost?
-$176
$176
$558
$105
none of the above
11.
a.
What will be the profit if the spread is held 90 days and the stock price is $45?
$36
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b.
c.
d.
e.
$20
$558
-$20
none of the above
Answer questions 12 through 17 about a long straddle constructed using the June 50 options.
12.
a.
b.
c.
d.
e.
What will the straddle cost?
$145
$690
$971
$413
none of the above
13.
a.
b.
c.
d.
e.
What are the two breakeven stock prices at expiration?
$55.58 and $45.87
$54.13 and $45.87
$55.58 and $44.42
$59.71 and $40.29
none of the above
14.
a.
b.
c.
d.
e.
What is the profit if the stock price at expiration is at $64.75?
-$971
$1,475
-$3,525
$500
none of the above
15.
a.
b.
c.
d.
e.
What is the profit if the position is held for 90 days and the stock price is $55?
-$971
-$58
-$109
-$471
none of the above
16.
Suppose the investor adds a call to the long straddle, a transaction known as a strap. What
will this do to the breakeven stock prices?
a.
lower both the upside and downside breakevens
b.
raise both the upside and downside breakevens
c.
raise the upside and lower the downside breakevens
d.
lower the upside and raise the downside breakevens
e.
none of the above
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17.
Suppose a put is added to a straddle. This overall transaction is called a strip. Determine
the profit at expiration on a strip if the stock price at expiration is $36.
a.
-$129
b.
$1,416
c.
$429
d.
$1,384
e.
none of the above
Answer questions 18 through 20 about a long box spread using the June 50 and 55 options.
18.
a.
b.
c.
d.
e.
What is the cost of the box spread?
$500
$2,018
$76
$484
none of the above
19.
a.
b.
c.
d.
e.
What is the profit if the stock price at expiration is $52.50?
$16
$500
–$234
$250
none of the above
20.
a.
b.
c.
d.
e.
What is the net present value of the box spread?
$9.84
$5.00
$16.00
$1.84
none of the above
21.
a.
b.
c.
d.
e.
Which of the following strategies does not profit in a rising market?
put bull spread
long straddle
collar
call bull spread
none of the above
22.
a.
b.
c.
d.
Which of the following transactions can have an unlimited loss?
long straddle
calendar spread
butterfly spread
reverse box spread
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e.
none of the above
23.
a.
b.
c.
d.
e.
Which of the following is the best strategy for an expected fall in the market?
long strip (2 puts and 1 call)
put bull spread
calendar spread
butterfly spread
none of the above
24.
a.
b.
c.
d.
e.
Early exercise is a disadvantage in which of the following transactions?
short box spread
put bear spread
long strip (2 puts and 1 call)
long strap (2 calls and 1 put)
none of the above
25.
a.
b.
c.
d.
e.
Which of the following have similar profit graphs?
call bull spread and long box spread
put bear spread and short box spread
butterfly spread and ratio spread
calendar spread and call bear spread
none of the above
26.
a.
b.
c.
d.
e.
The purchase of one option and the sale of another is known as
box
bear strategy
bull strategy
collar
spread
27.
The option strategy where the holder of a long position in a stock buys a put with an
exercise price lower than the current stock price and sells a call with an exercise price higher
than the current stock price is known as
a.
box
b.
bear strategy
c.
bull strategy
d.
collar
e.
spread
28.
a.
b.
c.
The profit from a put bear spread strategy when both options are out of the money is
–X1 + ST + P1 + X2 – ST – P2
–X1 + ST + P1 – P2
X1 – ST – P1 – X2 + ST + P2
202
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d.
e.
P1 + X 2 – ST – P2
P1 – P2
29.
“Like the butterfly spread, the calendar spread is one in which the underlying
instrument’s ___________ is the major factor in its performance.” The best word for the blank is
which of the following?
a.
volatility
b.
expected rate of return
c.
beta
d.
correlation with the benchmark index
e.
skewness
30.
a.
b.
c.
d.
e.
Which of the following statements best describes the nature of option time value decay?
time value decays more rapidly as the stock price approaches being at-the-money
time value decays more rapidly as expiration approaches
time value decays more rapidly for put option than call options
time value decay does not occur for collar option strategies
time value decay is detrimental for a trader who is short call options
203
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CHAPTER 7: ADVANCED OPTION STRATEGIES
TRUE/FALSE TEST QUESTIONS
T
F
1.
money spread.
A spread that is profitable if the options are in-the-money is called a
T
F
2.
Buying a put money spread is a bearish strategy.
T
F
rapidly.
3.
In a calendar spread the time value of the nearby option will decay more
T
F
increase.
4.
A call bear spread is a strategy for investors who expect stock prices to
T
F
5.
A call money spread that is closed prior to expiration has lower losses but
higher profits for each stock price than if held to expiration.
T
F
6.
There are three breakeven stock prices in a butterfly spread.
T
F
7.
spreads are used.
Early exercise is an important risk when call bear spreads and put bull
T
F
8.
A call butterfly spread combines a call bull spread with a call bear spread.
T
F
increase.
9.
A call butterfly spread is a bullish strategy that is profitable if stock prices
T
F
volatility.
10.
A reverse calendar spread is used to take advantage of unexpected high
T
F
different.
11.
One of the risks of a calendar spread is that the intrinsic values may be
T
F
12.
The holder of a straddle does not care which way the market moves as
long as it makes a significant move.
T
F
13.
If a straddle is closed prior to expiration, the investor can recover some of
the time value of either the call or the put but not both.
T
F
14.
An investor who holds a strap (2 calls and 1 put) believes the market is
more likely to go up than down.
204
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T
F
15.
A strip (2 puts and one call) would cost more than a straddle but would
pay off more if the stock falls.
T
F
16.
The payoffs form a straddle are more like the payoffs from a money
spread than a calendar spread.
T
F
17.
The risk of early exercise is of no concern to the holder of a long straddle.
T
F
exercised.
18.
At the expiration of a box spread, at most there will be only one option
T
F
19.
A box spread is a combination of a call bull spread and a put bear spread.
T
F
20.
A box spread is a good strategy to use if high volatility is expected.
T
F
21.
The delta of a straddle would be the call delta plus the put delta.
T
F
22.
A strap is a less expensive bullish strategy than a straddle.
T
F
23.
A collar gives downside protection, leaving the upside open.
T
F
24.
A ratio spread can be conducted with money spreads or time spreads.
T
F
25.
To truly gain from a straddle, an investor must have a better estimate of
volatility than everyone else.
T
F
26.
underlying instrument.
A spread option strategy is a transaction in one option and an opposite transaction in the
T
F
27.
The profit from a collar option strategy when the terminal stock price ends up in between
the two strike prices is ST – S0 – P1 + C2 where X2 > X1.
T
F
28.
The longer an investor holds a long call butterfly spread position,
everything else the same, the greater the distance between the breakeven stock prices.
T
F
29.
The breakeven points for a long straddle strategy are equidistant from the
current stock price regardless of the chosen strike price.
T
F
30.
The profit from a zero-cost collar option strategy when the terminal stock
price ends up in between the two strike prices is ST – S0 where X2 > X1.
CHAPTER 8: PRINCIPLES OF PRICING FORWARDS, FUTURES AND OPTIONS ON FUTURES
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CHAPTER 10: FORWARD AND FUTURES HEDGING, SPREAD, AND TARGET STRATEGIES
MULTIPLE CHOICE TEST QUESTIONS
1.
a.
b.
c.
d.
e.
A short hedge is one in which
the margin requirement is waived
the hedger is short futures
the hedger is short in the spot market
the futures price is lower than the spot price
none of the above
2.
a.
b.
c.
d.
e.
An anticipatory hedge is one in which
the basis is expected to fall
the hedger expects to make a profit on the futures
the spot position will be taken in the future
all of the above
none of the above
3.
a.
b.
c.
d.
e.
A strengthening of the basis means
the spot price rises more than the futures price
the futures price falls more than the spot price
a short hedger benefits
all of the above
none of the above
4.
a.
b.
c.
d.
e.
A hedge in which the asset underlying the futures is not the asset being hedged is
a cross hedge
an optimal hedge
a basis hedge
a minimum variance hedge
none of the above
5.
When the futures expires before the hedge is terminated and the hedger moves into the
next futures expiration, it is called
a.
spreading the hedge
b.
rolling the hedge forward
c.
optimally weighting the hedge
d.
all of the above
e.
none of the above
6.
The duration of the futures contract used in the price sensitivity hedge ratio is
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a.
price
b.
c.
d.
e.
the duration of the spot bond being hedged using the futures price instead of the spot
the duration of the deliverable bond using the spot price
the duration of the deliverable bond using the futures price
the duration of the overall bond portfolio
none of the above
7.
a.
b.
c.
d.
e.
Which technique can be used to compute the minimum variance hedge ratio?
duration analysis
present value
regression
all of the above
none of the above
8.
Which of the following measures is used in the price sensitivity hedge ratio for bond
futures?
a.
beta
b.
duration
c.
correlation
d.
variance
e.
none of the above
9.
Suppose you buy an asset at $50 and sell a futures contract at $53. What is your profit at
expiration if the asset price goes to $49? (Ignore carrying costs)
a.
–$1
b.
–$4
c.
$3
d.
$4
e.
none of the above
10.
Suppose you buy an asset at $70 and sell a futures contract at $72. What is your profit if,
prior to expiration, you sell the asset at $75 and the futures price is $78?
a.
–$1
b.
$2
c.
$1
d.
–$6
e.
none of the above
11.
a.
b.
c.
d.
Which of the following is not a reason for firms to hedge?
Firms can hedge less expensively than can their shareholders
Shareholders cannot tolerate mark-to-market losses
Hedging by corporations can have tax advantages
Shareholders are not always aware of their firms' risks
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e.
none of the above
12.
Find the profit if the investor buys a July futures at 75, sells an October futures at 78 and
then reverses the July futures at 72 and the October futures at 77.
a.
–3
b.
–2
c.
2
d.
1
e.
none of the above
13.
Determine the optimal hedge ratio for Treasury bonds worth $1,000,000 with a modified
duration of 12.45 if the futures contract has a price of $90,000 and a modified duration of 8.5
years.
a.
16.27
b.
15.93
c.
7.42
d.
11.11
e.
none of the above
14.
What is the profit on a hedge if bonds are purchased at $150,000, two futures contracts
are sold at $72,500 each, then the bonds are sold at $147,500 and the futures are repurchased at
$74,000 each?
a.
–$2,500
b.
–$5,500
c.
–$500
d.
–$3,000
e.
none of the above
15.
Find the optimal stock index futures hedge ratio if the portfolio is worth $1,200,000, the
beta is 1.15 and the S&P 500 futures price is 450.70 with a multiplier of 250.
a.
10.65
b.
12.25
c.
6123.80
d.
5325.05
e.
none of the above
16.
a.
b.
c.
d.
e.
In which of the following situations would you use a short hedge?
the planned purchase of a stock
the planned purchase of commercial paper
the planned issuance of bonds
the planned repurchase of stock to cover a short position
none of the above
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17.
You hold a stock portfolio worth $15 million with a beta of 1.05. You would like to lower
the beta to 0.90 using S&P 500 futures, which have a price of 460.20 and a multiplier of 250.
What transaction should you do? Round off to the nearest whole contract.
a.
sell 130 contracts
b.
sell 9,778 contracts
c.
sell 20 contracts
d.
buy 50,000 contracts
e.
sell 50,000 contracts
18.
You hold a bond portfolio worth $10 million and a modified duration of 8.5. What futures
transaction would you do to raise the duration to 10 if the futures price is $93,000 and its implied
modified duration is 9.25? Round up to the nearest whole contract.
a.
buy 109 contracts
b.
buy 17 contracts
c.
buy 669 contracts
d.
sell 100 contracts
e.
sell 669 contracts
19.
Which of the following statements about the use of futures in tactical asset allocation is
correct?
a.
Implementing tactical asset allocation using futures is a form of market timing.
b.
Futures can be used to synthetically buy or sell stocks but you cannot simultaneously adjust the beta or duration
c.
A difference between the portfolio held and the index on which the futures is based will
generate a gain for the investor.
d.
The use of futures in tactical asset allocation will generate cash from the synthetic sale,
which is then used in the synthetic purchase.
e.
None of the above
20.
Though a cross hedge has somewhat higher risk than an ordinary hedge, it will reduce
risk if which of the following occurs?
a.
futures prices are more volatile than spot prices
b.
the spot and futures contracts are correctly priced at the onset
c.
spot and futures prices are positively correlated
d.
futures prices are less volatile than spot prices
e.
none of the above
21.
a.
b.
c.
d.
e.
Which of the following correctly expresses the profit on a hedge?
the basis when the hedge is closed
the change in the basis
the spot profit minus the futures profit
the futures profit minus the spot profit
none of the above
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22.
a.
b.
c.
d.
e.
What happens to the basis through the contract's life?
it initially decreases, then increases
it initially increases, then decreases
it remains relatively steady
it moves toward zero
none of the above
23.
Find the profit if the investor enters an intramarket spread transaction by selling a
September futures at $4.5, buys an December futures at $7.5 and then reverses the September
futures at $5.5 and the December futures at $9.5.
a.
–3
b.
–2
c.
2
d.
1
e.
none of the above
24.
a.
b.
c.
d.
e.
Quantity risk is
the difficulty in measuring the volatility
the uncertainty about the size of the spot position
the risk of mismatching the futures maturity to the spot maturity
the possibility of regression error
none of the above
25.
called
a.
b.
c.
d.
e.
The relationship between the spot yield and the yield implied by the futures price is
26.
a.
b.
c.
d.
e.
All of the following are futures contract choice decisions related to hedging, except
which future underlying asset
which strike price
which futures contract expiration
whether to go long or short
all of the above are futures contract choice decisions
27.
a.
b.
c.
Hedging with futures contracts entails all of the following risks, except
marking to market may require large cash outflows
changes in margin requirements
basis risk
the yield beta
the price sensitivity
the tail
the hedge ratio
none of the above
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d.
e.
quantity risk
all of the above are potential risks
28.
Based on the minimum variance hedge ratio approach, what is the optimal number of
futures contracts to deploy, given the following information. The correlation coefficient between
changes in the underlying instrument’s price and changes in the futures contract price is 0.95, the
standard deviation of the changes in the underlying position’s value is 300%, and the standard
deviation of the changes in the futures contract’s price is 11.4%.
a.
long 35 futures contracts
b.
long 25 futures contracts
c.
long 15 futures contracts
d.
short 25 futures contracts
e.
short 15 futures contracts
29.
Based on the minimum variance hedge ratio approach what is the hedging effectiveness,
given the following information. The correlation coefficient between changes in the underlying
instrument’s price and changes in the futures contract price is 0.70, the standard deviation of the
changes in the underlying position’s value is 40%, and the standard deviation of the changes in
the futures contract’s price is 50%. (Select the closest answer.)
a.
50%
b.
45%
c.
40%
d.
35%
e.
30%
30.
Based on the price sensitivity hedge ratio approach, what is the optimal number of futures
contracts to deploy, given the following information. The yield beta is 0.65, the present value of
a basis point change for the underlying bond portfolio is $33,000, and the present value of a basis
point change for the bond futures contract is $325. (Select the closest answer.)
a.
long 100 futures contracts
b.
long 55 futures contracts
c.
short 66 futures contracts
d.
short 22 futures contracts
e.
short 11 futures contracts
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CHAPTER 10: FORWARD AND FUTURES HEDGING, SPREAD, AND TARGET STRATEGIES
TRUE/FALSE TEST QUESTIONS
T
F
1.
When a hedge is said to be a short hedge or a long hedge, it means that the
position is short or long in futures.
T
F
hedge.
2.
A hedge that is expected to earn a net profit is called an anticipatory
T
F
3.
A short hedger wants the basis to strengthen.
T
F
price.
4.
A hedge reduces risk because the futures price is less volatile than the spot
T
F
5.
A hedge that involves the use of a futures contract on an instrument that is
different from the instrument being hedged is called a cross hedge.
T
F
the hedger.
6.
The liquidity of the futures contract used in a hedge is very important to
T
F
7.
A hedger should select a contract that expires the same month as the date
on which the hedge is terminated.
T
F
8.
An individual who plans to take a foreign vacation could hedge the risk of
converting into the foreign currency by selling foreign currency futures.
T
F
9.
In the real-world, financial decisions are irrelevant, so there is really no
reason for firms to hedge.
T
F
10.
An optimal hedge ratio is one in which the change in the futures price
equals the change in the spot price.
T
F
positions.
11.
The price sensitivity hedge ratio uses the durations of the spot and futures
T
F
12.
The implied duration of a futures contract is the duration of the underlying
bond measured as if one owned the bond today.
T
F
13.
The measure of hedging effectiveness in a minimum variance hedge is the
size of profit on the hedge.
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T
F
14.
The price sensitivity hedge ratio would be more appropriate for interest
rate futures hedges than for commodity futures hedges.
T
F
15.
The minimum variance hedge ratio uses current information while the
price sensitivity hedge ratio uses past information.
T
F
16.
spot market.
If you plan to issue a liability in the future, you are currently short in the
T
F
17.
A firm that expects to borrow in the future would use a short hedge to
protect against interest rate changes.
T
F
18.
Since it states that systematic risk cannot be eliminated, modern portfolio
theory does not allow for stock index futures contracts.
T
F
19.
An investor who expects to purchase stock at a later date would use a short
hedge to protect against stock price movements.
T
F
20.
A hedge of a specific stock's price with stock index futures will reduce
both systematic and unsystematic risk.
T
F
21.
The basis is the ratio of the futures price to the spot price.
T
F
22.
Although a hedge might not be perfect, it should be partially effective if
the spot and futures prices move in opposite directions.
T
F
23.
When the target duration is set at zero, the correct number of futures
contracts to use is the same as is obtained from the price sensitivity hedge ratio.
T
F
24.
Hedging can be viewed as a form of speculation, inasmuch as it involves
taking a position that something bad will happen.
T
F
25.
The risk of the basis is usually less than the risk of the spot position.
T
F
26.
Based on the price sensitivity hedge ratio, if the yield beta increases
(assumed to be positive), then the optimal number of futures contracts increases. Assume the
durations are positive.
T
F
27.
Based on the price sensitivity hedge ratio, if the modified duration of the
futures contract increases (assumed to be positive), then the optimal number of futures contracts
increases. Assume the durations are positive.
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T
F
28.
A foreign currency long hedge with a $/¥ futures contract will be a foreign
currency short hedge with a ¥/$ futures contract.
T
F
29.
If the target beta exceeds the underlying’s beta, then the manager will go
long the futures contract.
T
F
30.
Alpha capture seeks to achieve excess returns from identifying
underpriced securities while eliminating unsystematic risk.
CHAPTER 11: SWAPS
MULTIPLE CHOICE TEST QUESTIONS
1.
a.
b.
c.
d.
e.
The difference between the swap rate and the rate on a Treasury security of the same maturity is called the
swap spread
risk premium
swap basis
settlement spread
LIBOR
2.
a.
b.
c.
d.
e.
Interest rate swap payments are made
on the last day of the quarter
on the first day of each month
at whatever dates are agreed upon by the counterparties
on the 15th of the agreed-upon months
on the last day of the month
3.
a.
b.
c.
d.
e.
To determine the fixed rate on a swap, you would
use put-call parity
price it as the issuance of a fixed rate bond and purchase of a floating rate bond or vice versa
use the same fixed rate as that of a zero coupon bond of equivalent maturity
use the continuously compounded rate for the shortest maturity bond
none of the above
4.
a.
b.
c.
d.
e.
Which of the following is not a type of swap?
settlement swaps
commodity swaps
interest rate swaps
equity swaps
currency swaps
5.
a.
b.
c.
d.
e.
The underlying amount of money on which the swap payments are made is called
settlement value
market value
notional amount
base value
equity value
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6.
a.
b.
c.
d.
e.
The most basic and common type of swap is called
basis swap
plain vanilla swap
plain paper swap
commercial swap
bond swap
7.
a.
b.
c.
d.
e.
An interest rate swap with both sides paying a floating rate is called a
plain vanilla swap
two-way swap
floating swap
spread swap
basis swap
8.
Consider a swap to pay currency A floating and receive currency B floating. What type of swap would be
combined with this swap to produce a swap to produce a plain vanilla swap in currency B.
a.
pay currency B floating, receive currency A fixed
b.
pay currency B fixed, receive currency A floating
c.
pay currency B fixed, receive currency A fixed
d.
pay currency B floating, receive currency A floating
e.
none of the above
9.
For a currency swap with $10 million notional amount, the notional amount in British pounds if the exchange
rate is $1.55 is (approximately)
a.
₤11.55 million
b.
₤15.5 million
c.
₤10 million
d.
₤6.45 million
e.
none of the above
10.
a.
b.
c.
d.
e.
A currency swap without the exchange of notional amount is most likely to be used in what situation?
a company issuing a bond
a company generating cash flows in a foreign currency
a company arranging a loan
a dealer trying to hedge a currency option
none of the above
11.
a.
b.
c.
d.
e.
Which of the following distinguishes equity swaps from currency swaps?
equity swap payments are always hedged
equity swap payments are made on the first day of the month
equity swap payments can be negative
equity swap payments have more credit risk
none of the above
12.
Find the upcoming net payment in a plain vanilla interest rate swap in which the fixed party pays 10 percent
and the floating rate for the upcoming payment is 9.5 percent. The notional amount is $20 million and payments are
based on the assumption of 180 days in the payment period and 360 days in a year.
a.
fixed payer pays $1,950,000
b.
fixed payer pays $950,000
c.
floating payer pays $1 million
d.
floating payer pays $50,000
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e.
fixed payer pays $50,000
13.
Find the upcoming payment interest payments in a currency swap in which party A pays U. S. dollars at a
fixed rate of 5 percent on notional amount of $50 million and party B pays Swiss francs at a fixed rate of 4 percent on
notional amount of SF35 million. Payments are annual under the assumption of 360 days in a year, and there is no
netting.
a.
party A pays $2,500,000, and party B pays SF1,400,000
b.
party A pays SF1,400,000, and party B pays $2,500,000
c.
party A pays SF1,750,000, and party B pays SF1,400,000
d.
party A pays $2,500,000, and party B pays $2,000,000
e.
party A pays $50 million, and party B pays SF35 million
14.
Find the net payment on an equity swap in which party A pays the return on a stock index and party B pays a
fixed rate of 6 percent. The notional amount is $10 million. The stock index starts off at 1,000 and is at 1,055.15 at the
end of the period. The interest payment is calculated based on 180 days in the period and 360 days in the year.
a.
party B pays $851,500
b.
parry B pays $48,500
c.
party B pays $251,500
d.
party A pays $251,500
e.
party A pays $851,500
15.
Find the approximate upcoming net payment on an equity swap in which party A pays the return on stock
index 1 and party B pays the return on stock index 2. The notional amount is $25 million. Stock index 1 starts the
period at 1500 and goes up to 1600 at the end of the period. Stock index 2 starts the period at 3500 and goes up to 3300
at the end of the period.
a.
The party paying index 1 pays about $238,000
b.
The party paying index 2 pays about $238,000
c.
The party paying index 2 pays about $3.095 million
d.
The party paying index 1 pays about $25 million
e.
The party paying index 1 pays about $3.095 million
16.
Find the fixed rate on a plain vanilla interest rate swap with payments every 180 days (assume a 360-day year)
for one year. The prices of Eurodollar zero coupon bonds are 0.9756 (180 days) and 0.9434 (360 days).
a.
5.9 percent
b.
5 percent
c.
6 percent
d.
5.5 percent
e.
2.95 percent
17.
2,000.
a.
b.
c.
d.
e.
Use the information in problem 16 to find the fixed rate on an equity swap in which the stock index is at
5.9 percent
5 percent
6 percent
2.95 percent
3.5 percent
18.
Find the market value of a plain vanilla swap from the perspective of the fixed rate payer in which the
upcoming payment is in 30 days, and there is one more payment 180 days after that. The fixed rate is 7 percent and the
upcoming floating payment is at 6.5 percent. The notional amount is $15 million. Assume 360 days in a year. The
prices of Eurodollar zero coupon bonds are 0.9934 (30 days) and 0.9528 (210 days).
a.
the fixed payer pays $31,763.75
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b.
c.
d.
e.
the fixed payer pays $71,527.50
the floating payer pays $49,500
the floating payer pays $194,228
none of the above
19.
a.
b.
c.
d.
e.
Which of the following statements about constant maturity swaps is not true?
the CMT rate is linked to a U. S. treasury security of equivalent maturity
the typical maturity is 2 to 5 years
the maturity is constant
one rate is based on a security of a longer rate than the settlement period
the swap is a type of interest rate swap
20.
a.
b.
c.
d.
e.
Which of the following is not a way to terminate a swap:
the two counterparties cash settle the market value
enter into an opposite swap with another counterparty
hold the swap to its maturity date
use a forward contract or option on the swap to enter into an offsetting swap
borrow the notional amount and pay off the counterparty
21.
An equity swap with fixed interest payments has two payments remaining. The first occurs in 30 days and the second occurs in 210 days. The discount factors are 0.9934 (30 days) and
0.9528 (210 days). The upcoming fixed payment is at 4 percent and is based 180 days in a 360day year. The equity index was at 1150 at the beginning of the period and is now at 1152.75. The
notional amount is $60 million. Find the approximate value of the equity swap from the perspective of the party making the equity payment and receiving the fixed payment.
a.
b.
c.
d.
e.
$143,478
$642,000
-$143,478
-$642,000
-$496,560
22.
The present value of the series of dollar payments in a currency swap per $1 notional amount is $0.03. The
present value of the series of euro payments in the same currency swap per €1 is €0.0225. The current exchange rate is
$1.05 per euro. If the swap has a notional amount of $100 million and €105 million, find the market value of the swap
from the perspective of the party paying euros and receiving dollars.
a.
$519,375
b.
–$2,480,625
c.
$3,000,000
d.
–$3,000,000
e.
–$519,375
23.
a.
b.
c.
d.
e.
Equity swaps can be used for all of the following except:
to synthetically buy stock
to synthetically sell stock
to convert dividends into capital gains
to synthetically re-align an equity portfolio
none of the above
24.
a.
Which of the following statements about diff swaps is true?
they involve interest payments in separate currencies
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b.
c.
d.
e.
they are based on the difference between interest rates in two countries
they are based on the difference between interest rates of different maturities
the notional amount reduces throughout the life of the swap
the notional amount increases throughout the life of the swap
25.
a.
b.
c.
d.
e.
Interest rate swaps can be used for all of the following purposes except:
to borrow at the prime rate
to convert a fixed-rate loan into a floating-rate loan
to convert a floating-rate loan into a fixed-rate loan
to speculate on interest rates
to hedge interest rate risk
26.
a.
b.
c.
d.
e.
The value of a pay-fixed, receive floating interest rate swap is found as the value of a
floating-rate bond times the value of a fixed-rate bond.
floating-rate bond plus the value of a fixed-rate bond.
floating-rate bond minus the value of another floating-rate bond.
fixed-rate bond minus the value of another fixed-rate bond.
floating-rate bond minus the value of a fixed-rate bond.
27.
A basis swap is priced by adding a spread to the higher rate or subtracting a spread from the lower rate.
This spread is found as
a.
the difference between the floating rate on a plain vanilla swap based on one of the rates and the fixed rate
on a plain vanilla swap based on the other rate.
b.
the addition of the fixed rate on a plain vanilla swap based on one of the rates and the fixed rate on a plain
vanilla swap based on the other rate.
c.
the difference between the fixed rate on a plain vanilla swap based on one of the rates and the fixed rate on
a plain vanilla swap based on the other rate.
d.
the difference between the floating rate on a plain vanilla swap based on one of the rates and the floating
rate on a plain vanilla swap based on the other rate.
e.
none of the above correctly explain how this spread is found
28.
a.
b.
c.
d.
e.
The value of a pay-fixed, receive-floating interest rate swap is found as the value of a
floating-rate bond minus the value of a fixed-rate bond.
fixed-rate bond minus the value of a floating-rate bond.
floating-rate bond minus the value of another floating-rate bond.
fixed-rate bond minus the value of another fixed-rate bond.
none of the above correctly identify how this value is found.
29.
Swap payments typically involve adjusting for the fraction of the year in some fashion. This adjustment is
known as
a.
the compounding convention
b.
the accrual period
c.
the fraction convention
d.
the money market convention
e.
the payment period
30.
The combination of a pay euro fixed and receive dollar fixed swap with a pay dollar floating and receive
euro fixed results in
a.
a currency swap
b.
a currency swap, receive euro fixed and pay euro floating
c.
an interest rate swap, pay dollar fixed and receive dollar floating
d.
an interest rate swap, receive euro fixed and pay euro floating
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e.
an interest rate swap, pay dollar floating and receive dollar fixed
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CHAPTER 11: SWAPS
TRUE/FALSE TEST QUESTIONS
T
F
1.
Swap payments are always either fixed or floating but never both.
T
F
2.
The notional amount is never exchanged in an interest rate swap.
T
F
3.
Currency swap volume is greater than equity swap volume.
T
F
4.
Interest rate swap volume is greater than currency swap volume because virtually ever
business is exposed to interest rate risk.
T
F
5.
In an interest rate swap, the upcoming floating payment will not be determined until the end
of the current settlement period.
T
F
6.
A swap involving two floating rates is called a basis swap.
T
F
7.
The value of a floating-rate bond is par on each interest payment date.
T
F
8.
The market value of a swap is zero between settlement dates.
T
F
9.
A company that borrows at a floating rate and uses a swap to convert into a fixed rate is
assuming some credit risk.
T
F
10.
In an index amortizing swap, the notional amount increases throughout the life of the swap.
T
F
11.
A currency swap with no notional amount can be used to synthetically convert a bond
issued in one currency into a bond issued in another currency.
T
same.
F
12.
An interest rate swap is a special case of a currency swap with both currencies being the
T
F
13.
The fixed rates on a currency swap are the same as the fixed rates on plain vanilla interest
rate swaps in the respective currencies.
T
F
14.
Currency swaps can result in savings for a party due to the assumption of credit risk.
T
F
15.
Like interest rate and currency swaps, equity swap payments are always positive.
T
F
16.
sell short the other.
A strategy to replicate an equity swap involving two stock indices is to buy one index and
T
F
17.
The level of the stock is irrelevant to the pricing of equity swaps.
T
F
18.
A risk of equity swaps is that the company will pay dividends.
T
F
19.
A plain vanilla interest rate swap is equivalent to issuing a fixed-rate bond and using the
proceeds to buy a floating-rate bond or vice versa.
T
F
payment.
20.
A swap can be terminated by having the party owing the greater amount make a cash
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T
F
21.
If a swap is effectively terminated by entering into the opposite swap with another
counterparty, the credit risk will be eliminated.
T
F
22.
The settlement period in a swap refers to the full life of the swap.
T
F
23.
Swaps are created in the over-the-counter market.
T
F
of a bond.
24.
By adding a hypothetical notional amount to a swap, one can treat the cash flows like those
T
F
25.
At the beginning of the life of the swap, the present values of the two stream of payments of
each counterparty is the same.
T
F
each year.
26.
Since 1998, the notional amount of interest rate swaps outstanding has always increased
T
F
each year.
27.
Since 1998, the gross market value of currency swaps outstanding has always increased
T
28.
Interest rate swaps can be viewed as a portfolio of forward contracts.
F
T
F
29.
different currency.
Currency swaps can be viewed as a pair of bonds with each bond denominated in a
T
F
30.
Pricing a currency swap means to find the fixed rates in the two currencies. These fixed
rates are the same as the fixed rates on plain vanilla swaps in the respective currencies.
CHAPTER 12: INTEREST RATE FORWARDS AND OPTIONS
MULTIPLE CHOICE TEST QUESTIONS
1.
a.
b.
c.
d.
e.
Which of the following is a 1 x 4 FRA?
The FRA expires in one month, and the underlying Eurodollar expires in three months.
The FRA expires in four months, and the underlying Eurodollar expires in one month.
The FRA expires in one month, and the underlying Eurodollar expires in four months.
The FRA expires in three months, and the underlying Eurodollar expires in four months.
The FRA expires in one month, and the underlying Eurodollar expires in five months.
2.
Determine the value of an interest rate call option at the maturity of a loan if the call has a
strike of 12 percent, a face value of $50 million, the loan matures 90 days after the call is
exercised, the call expires in 60 days, the call premium is $200,000, and LIBOR ends up at 13
percent.
a.
$125,000
b.
$83,333
c.
$208,000
d.
–$75,000
e.
none of the above
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CHAPTER 14: FINANCIAL RISK MANAGEMENT TECHNIQUES AND APPPLICATIONS
MULTIPLE CHOICE TEST QUESTIONS
1.
a.
b.
c.
d.
e.
Risk management encompasses all of the following except
determining a firm’s actual level of risk
determining a firm’s desired level of risk
setting policies and procedures
monitoring your position after-the-fact
none of the above
2.
a.
b.
c.
d.
e.
Market risk is which of the following
the risk associated with failing to properly record market transactions
the risk that a dealer will lose market share to a competing dealer
the risk associated with movements in such factors as interest rates and exchange rates
the risk of the government declaring a transaction illegal
none of the above
3.
a.
b.
c.
d.
e.
What is the reason for undertaking a gamma hedge?
government regulation
the possibility of counterparty default
changes in volatility
large movements in the underlying
none of the above
4.
Which of the following is the interpretation of a VAR of $5 million for one year at 5
percent probability.
a.
the probability is 5 percent that the firm will lose at least $5 million in one year
b.
the probability is at least 5 percent that the firm will lose $5 million in one year
c.
the probability is 5 percent that the firm will lose $5 million in one year
d.
the probability is less than 5 percent that the firm will lose $5 million in one year
e.
none of the above
5.
a.
b.
c.
d.
e.
Which of the following are not methods of determining the VAR?
simulation method
historical method
estimation method
analytical method
none of the above
6.
Which of the following methods is not used to reduce credit risk?
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a.
b.
c.
d.
e.
delta-gamma-vega hedging
collateral
marking to market
limiting the amount of business you do with a party
none of the above
7.
a.
b.
c.
d.
e.
Which of the following are types of risks faced by a derivatives dealer?
tax risk
operational risk
accounting risk
legal risk
none of the above
8.
a.
b.
c.
d.
e.
Netting permits a firm to?
subtract losses from price increases from losses from price decreases
net its transactions with a given counterparty against each other
net all of its gains against all of its losses
all of the above
none of the above
9.
a.
b.
c.
d.
e.
Systemic risk is
the risk of a failure of the entire financial system
the risk associated with broad market movements
the risk of a failure of a firm’s financial risk management system
the risk of large price movements throughout the financial system
none of the above
10.
Which of the following is the primary impetus for the growth in the practice of risk
management?
a.
faster computers
b.
better pricing models
c.
improved knowledge of risk management
d.
tighter government regulation
e.
concern over volatility
11.
Each of the following is a benefit of practicing risk management by companies except
a.
companies can manage risk better than their shareholders
b.
risk management can avoid bankruptcy costs
c.
risk management can lower taxes
d.
risk management can increase employment opportunities
e.
risk management can help prevent companies from passing up valuable investment
opportunities
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12.
Find the number of Eurodollar futures each having a delta of –$25 that would delta-hedge
a portfolio of a long position in swaps with a delta of $5,000 and a short position in a put option
with a delta of –$2,300.
a.
long 292 contracts
b.
short 108 contracts
c.
short 292 contracts
d.
long 200 contracts
e.
long 108 contracts
13.
a.
b.
c.
d.
e.
A total return swap is best described as
A swap in which the payments include only capital gains
a swap in which the total return on a stock index is swapped for the total return on a bond
a swap in which the return on one bond is swapped for some other payment
a swap designed to substitute for a basis swap
none of the above
14.
a.
b.
c.
d.
e.
Which of the following best describes a credit default swap?
it is protected against default
it has a higher rate to compensate for the possibility of one party defaulting
it carries a higher credit rating than most other swaps
it off if another party external to the swap defaults
none of the above
15.
a.
b.
c.
d.
e.
16.
a.
b.
c.
d.
e.
Which of the following statements is not true about a credit spread option?
it is an option on the spread of a bond over a reference bond
its value would change with changes in investors’ perceptions of a party’s credit quality
it requires payment of a premium up front
it requires that the underlying bond be relatively liquid
none of the above
Which of the following forms of hedging requires the use of options?
delta hedging
vega hedging
gamma hedging
credit risk hedging
none of the above
17.
If a firm engages in risk management to capture arbitrage profits, what is it easy to
overlook?
a.
the additional credit risk it assumes
b.
the cost is greater than the benefit
c.
the market risk is high
d.
all of the above
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e.
none of the above
18.
a.
b.
c.
d.
e.
Which of the following best describes the delta normal method?
a method of managing a delta hedge to assure a low gamma
the historical method when the distribution is normal
the Monte Carlo method when price changes are normally distributed
the analytical method applied to options
a method of measuring changes in an option’s delta
19.
a.
b.
c.
d.
e.
The risk that errors can occur in inputs to a pricing model is called
input risk
model risk
pricing risk
valuation risk
none of the above
20.
Which of the following techniques is a more appropriate risk management tool for a
company in which asset value is not easily measurable?
a.
stress risk
b.
credit value at risk
c.
market risk
d.
delta at risk
e.
cash flow at risk
21.
a.
b.
c.
d.
e.
In option terms, the limited liability of corporate stockholders is
a forward contract
a call option
a put option
a protective put
a fiduciary call
22.
a.
b.
c.
d.
e.
The risk that a party will not pay while the counterparty is sending payment is called
wire transfer risk
payment risk
settlement risk
cross-border risk
none of the above
23.
a.
b.
c.
d.
A bond subject to default is equivalent to
a payer swaption
a call and a default-free bond
a put and a call
a default-free bond and a short put
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e.
none of the above
24.
Which of the following instruments could be used to execute a delta, gamma and vega
hedge?
a.
a swap
b.
an option
c.
a futures
d.
an FRA
e.
none of the above
25.
Which of the following is approximately the Value at Risk at 5 percent of a portfolio of $10 million of asset
A, whose expected return is 15 percent and volatility is 35 percent, and $15 million of asset B, whose expected
return is 21 percent and volatility is 30 percent, where the correlation between the two assets is 0.2.
a.
b.
c.
d.
e.
26.
a.
b.
c.
d.
e.
$5.6 million
$10 million
$15 million
$1.25 million
none of the above
A delta-hedged position is one in which the
combined spot and derivatives positions have a delta of one.
spot position has a delta of zero.
derivatives position has a delta of zero.
combined spot and derivatives positions have a delta of zero.
combined spot and derivatives positions have a gamma of zero.
27.
A delta and gamma hedge is
a.
one in which the combined spot and derivatives positions have a delta of zero and a
gamma of zero.
b.
one that is not guaranteed to be free of all risks
c.
effective only for small changes in the underlying instrument.
d.
all of the above statements are true
e.
none of the above statements are true
28.
a.
b.
c.
d.
e.
Which of the following positions has a negative vega?
Receive fixed and pay floating LIBOR-based interest rate swap contract
Short cattle futures contract
Receive floating, pay fixed LIBOR-based forward rate agreement
Long Apple, Inc. put option
Short S&P 500 index call option
29.
a.
Delta, gamma, and vega hedging is rather complex. Identify the false statement.
Requires the use of four hedging instruments
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b.
c.
d.
e.
At least one of the instruments has to be an option
Involves designing a portfolio where delta, gamma, and vega are set equal to zero
Typically involves the solution to three simultaneous equations
All of the above statements are true
30.
a.
b.
c.
d.
e.
Which of the following is not a method for computing Value at Risk?
Analytical method
Variance-covariance method
Comprehensive method
Historical method
Delta normal method
31.
The present value of the payments made to convert a bond subject to default to a defaultfree bond is called the
a.
Insurance cost
b.
Credit default swap premium
c.
Annuity risk factor
d.
Present value of the default volatility
e.
None of the above
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CHAPTER 14: FINANCIAL RISK MANAGEMENT TECHNIQUES AND
APPPLICATIONS
TRUE/FALSE TEST QUESTIONS
T
F
1.
Value at Risk.
Earnings at Risk is a better risk measure for a derivatives dealer than is
T
F
2.
One good reason for practicing risk management is that arbitrage
opportunities can be earned.
T
F
3.
Conditional Value at Risk is the expected loss, given that a loss occurs.
T
F
4.
The equity of a company with leverage is a put option on the assets.
T
F
5.
If a firm holds a position in an option, it can delta and gamma hedge the
position by adding a position in another option.
T
F
6.
Current credit risk is encountered is by only one party at a time in a swap.
T
F
7.
Potential credit risk is encountered by only one party at a time in a swap.
T
F
8.
A dealer who engages in derivatives transactions with customers of low
credit quality will offer a less attractive rate.
T
risk
F
9.
T
F
10.
Netting allows a significant reduction in credit risk but increases market
A credit default swap is an ordinary swap that is subject to default.
T
F
11.
The credit risk in an interest rate swap is smallest at the beginning and at
the end of the life of the swap.
T
F
12.
Eurodollar futures are widely used to hedge gamma and vega risk.
T
risk.
F
13.
Operational risk is more difficult to manage than market risk and credit
T
F
14.
Vega hedging is required only in options portfolios.
T
F
15.
Value at Risk provides an estimate of the worst possible loss a firm can
incur with a given probability.
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T
F
16.
Value at Risk estimates for portfolios must take into account the
correlations among the various assets and liabilities in a portfolio.
T
F
17.
Stress testing allows a firm to see how its portfolio will behave under
extremely rare but favorable conditions.
T
F.
18.
Credit derivatives are derivatives that are insured against credit losses.
T
F
19.
Model risk can occur when the wrong pricing models are used.
T
F
20.
Companies can benefit from risk management if their incomes fluctuate
across different tax brackets.
T
F
21.
The analytical (variance-covariance) method of estimating Value at Risk
requires the assumption of a normal distribution.
T
F
22.
The historical method of estimating Value at Risk uses the performance of
the portfolio over the last ten years.
T
F
23.
The Monte Carlo simulation method of estimating Value at Risk is one of
the most flexible methods because it permits the user to assume any probability distribution.
T
F
24.
A total return swap allows substitution of the total return on a bond for the
total return on a loan of comparable maturity.
T
F
25.
Legal risk is the risk that the government will declare derivatives illegal.
T
F
costs.
26.
One reason firms manage risk with derivatives is to lower bankruptcy
T
F
27.
Credit risk is the uncertainty of a firm’s value or cash flow that is
associated with movements in an underlying source of risk.
T
F
28.
A delta and gamma hedge is one in which the combined spot and
derivatives positions have a delta of zero and a gamma of zero.
T
F
29.
The historical method for computing Value at Risk estimates the
distribution of the portfolio’s performance by collecting data on the past performance of the
portfolio and using it to estimate the future probability distribution.
T
F
30.
Stress testing is one method of estimating Value at Risk.
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T
F
credit risk.
31.
A CDS premium is paid by the CDS seller to the CDS buyer to transfer the
CHAPTER 15: MANAGING RISK IN AN ORGANIZATION
MULTIPLE CHOICE TEST QUESTIONS
1.
a.
b.
c.
d.
e.
Derivatives activities in end users are primarily conducted by
the human resources group
the sales staff
the chief financial officer
the board of directors
the treasury group
2.
Which of the following best describes a company that practices enterprise risk
management?
a.
interest rate risk and currency risk would be managed in unison
b.
a single department to manage risk
c.
it would manage insurance-related risks along with financial risk
d.
credit risk would be managed the same way as market risk
e.
operational risk would be managed
3.
a.
b.
c.
d.
e.
The front office refers to
the compliance office
the traders who engage in derivatives transactions
legal counsel
the risk management function
senior management
4.
a.
b.
c.
d.
e.
FAS 133 defines effective hedging as
a hedge with no basis risk
a correctly priced hedge
a perfect hedge
a hedge that reduces 80 to 125 percent of the risk
none of the above
5.
a.
b.
c.
d.
e.
In which of the following activities is hedge accounting prohibited?
hedging an overall portfolio as opposed to an individual transaction
using short calls to protect a long asset
using long puts to protect an asset
hedging a long position with a short futures
hedging a swap with a swaption
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6.
Which of the following organizations recommends best practices for the investment
management industry?
a.
PRMIA
b.
Risk Standards Working Group
c.
GARP
d.
G-30
e.
Financial Accounting Standards Board
7.
a.
b.
c.
d.
e.
Which of the following activities does senior management not do?
ensure that personnel are qualified
ensure that controls are in place
execute hedge transactions
establish policies
define roles and responsibilities
8.
a.
b.
c.
d.
e.
The primary distinction between FAS 133 and IAS 39 is
IAS 39 does not permit hedge accounting
IAS 39 was adopted earlier than FAS 133
IAS 39 applies only to publicly traded corporations
IAS 39 applies to all financial assets and liabilities, not just derivatives
none of the above
9.
a.
b.
c.
d.
e.
Metalgesellschaft lost about $1.3 billion doing what?
hedging short-term commitments with long-term options
using crude oil futures options to hedge crude oil futures
trading futures spreads on crude oil
hedging fixed rate oil price commitments with swaptions
none of the above
10.
a.
b.
c.
d.
e.
“Independent risk management” means which of the following?
that risk management of a firm is independent of its overall corporate policy decisions
that the risk management function is provided by an outside consulting firm
that the risk manager cannot be influenced by the traders
that the risk manager is independent of the firm’s senior managers
none of the above
11.
a.
b.
c.
d.
e.
End users are all of the following types of organizations except?
investment funds
non-financial corporations
governments
financial institutions
none of the above
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12.
a.
b.
c.
d.
e.
What is the primary activity of a firm’s front office?
risk management
trading
pricing derivative products
auditing
none of the above
13.
a.
b.
c.
d.
e.
Orange County lost $1.6 billion doing what?
betting that interest rates would remain stable
buying Treasury bond futures
selling Eurodollar futures
buying short- and intermediate-term bonds on margin
trading money market options
14.
a.
b.
c.
d.
e.
Risk managers should report to
the chief trader
legal counsel
the executive in charge of the front office
the executive in charge of the back office
none of the above
15.
a.
b.
c.
d
e.
Prior to FAS 133, where on the financial statements were derivatives reported?
as contingent liabilities
as goodwill
as intangible assets
nowhere because they were off-balance sheet items
in Other Comprehensive Income
16.
a.
b.
c.
d
e.
Which of the following methods is not acceptable for disclosure under the SEC’s rules?
the CEO’s letter to the shareholders
tabular information
sensitivity analysis
VAR
none of the above
17.
a.
b.
c.
d.
e.
Ultimate authority for risk management lies with
legal counsel
the head trader
senior management
the internal auditors
the external auditors
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18.
Derivatives dealers primarily conduct derivatives transactions for which of the following
reasons?
a.
to enhance the returns on their other investment transactions
b.
to profit off of their ability to execute trades at the right time
c.
to profit off of their market making services
d.
to provide services to enhance the overall attractiveness of their product line
f.
none of the above
19.
a.
b.
c.
d.
e.
Which of the following methods is not permitted to satisfy the SEC’s requirements for disclosure of derivatives activity?
an explanation in the chairman’s letter
a Value-at-Risk figure
a sensitivity analysis
a table of market values and related terms
none of the above
20.
a.
b.
c.
d.
e.
Hedge accounting is which of the following?
describing all hedges in footnotes to accounting statements
deferring all recording of hedge profits and losses until the hedge is over
associating the derivative profit or loss with the instrument being hedged
all of the above
none of the above
21.
a.
b.
c.
d.
e.
Which of the following statements is not true about fair value hedges?
it requires a method of determining the fair value of the derivative
it defers recognition of all profits and losses until the hedge is terminated
it will cause earnings to fluctuate if hedges are not effective
it requires proper documentation
none of the above
22.
a.
b.
c.
d.
e.
Which of the following statements is not true about fair value hedges?
it requires identification of the effective and ineffective parts
derivatives profits and losses are temporarily carried in an equity account
it requires proper documentation
only dealer firms are eligible to use it
none of the above
23.
a.
b.
c.
d.
e.
Barings lost $1.2 billion because of what?
a failure of risk controls in one of its foreign offices
model risk in their VAR models
fraudulent transactions
regulators shut it down because of poor risk management
speculating on German interest rates
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24.
U. S.?
a.
b.
c.
d.
e.
Which of the following would not be included among typical derivatives end users in the
25.
a.
b.
c.
d.
e.
Procter and Gamble lost $157 million doing what?
speculating on a worldwide recession
failure to hedge their borrowing cost on a bond issue
speculating on foreign interest and exchange rates
speculating on a decrease in the federal budget deficit
mismanagement of a hedge fund in their pension fund
26.
a.
b.
c.
d.
e.
All of the following make up the financial derivatives risk management industry, except
end users
dealers
consultants
specialized software companies
GRAP professionals
pension funds
corporations
state and local governments
the federal government
hedge funds
27.
Enterprise risk management includes all of the following except
a.
a process in which a firm seeks to controls all of its risks in a centralized, integrated
manner
b.
seeks to manage traditional financial risks, such as interest rate and foreign currency risks
c.
seeks to manage risk of product obsolescence risk
d.
seeks also to manage nontraditional financial risks, such as insurable risks
e.
all of the above
28.
a.
b.
c.
d.
e.
Hedge accounting, based on FAS 133, addresses all of the following except
fair value hedges
unfair value hedges
cash flow hedges
foreign investment hedges
speculation
29.
a.
b.
c.
d.
e.
Responsibilities of senior management include all of the following except
establish written policies
define roles and responsibilities
identify acceptable strategies
ensure that control systems are in place
all of the above
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30.
a.
b.
c.
d.
e.
Hedge accounting is a method of accounting for which the
gains and losses from a hedge are deferred until the hedge is completed.
debits and credits are managed to keep the cash account stable
derivatives revenues and expenses are recorded so as to exactly balance
gains and losses on derivatives are shown before the hedge is terminated
none of the above
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CHAPTER 16: MANAGING RISK IN AN ORGANIZATION
TRUE/FALSE TEST QUESTIONS
T
F
1.
T
F
2.
than do dealers.
The United States government, in general, does not use derivatives.
End users typically invest more resources in their derivatives operations
T
F
3.
End users differ from dealers in that the latter engage in risk management
transactions for the purpose of earning a profit off the spread between their buying and selling
prices, while the former enter into transactions to manage specific risks.
T
F
4.
than end users.
Dealers typically have more sophisticated risk management operations
T
F
5.
An effective risk management system requires that the risk manager be
independent of the derivatives traders.
T
F
6.
A risk management system that controls risk within a single department is
considered to be centralized.
T
F
7.
office personnel.
In a derivatives operations, back office personnel are in charge of front
T
F
ways.
Under SEC rules, derivatives activities must be disclosed in one of three
8.
T
F
9.
Risk management in which risks such as financial market risk and
insurance risk are managed jointly is called enterprise risk management.
T
F
10.
Barings Bank failed due to excessive government regulation of their
derivatives activities.
T
F
11.
Cash flow accounting must be used for all hedges involving cash outlays.
T
F
12.
The purpose of IAS 39 is to prescribe standards for derivatives accounting
for foreign currency transactions.
T
F
13.
A corporate risk management function is typically carried out by the
treasury department.
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T
F
14.
By speculating in derivatives, Procter and Gamble used its treasury
department as a profit center.
T
F
15.
Legal support for derivatives dealers is done by a compliance officer.
T
F
Income.
16.
Prior to FAS 133, derivatives were accounted for in Other Comprehensive
T
F
17.
an asset held.
A fair value hedge is a transaction designed to protect the market value of
T
F.
18.
Transactions that do not qualify as hedges must be accounting for as
speculation and marked to market each period.
T
F
all risks.
19.
SEC disclosure requirements force companies to reveal how they manage
T
F
20.
Senior management should be involved in the setting of policies and
procedures of a firm’s risk management operations.
T
risk.
F
21.
The G-30 report recommends how institutional investors should manage
T
F
22.
adjusted basis.
Senior management should evaluate trading performance on a risk-
T
F
23.
call options.
Under FAS 133 executive stock options must be accounted for as short
T
F
24.
A company’s auditors are not typically trained to serve in a risk
management capacity.
T
F
25.
The basic premise behind FAS 133 is that derivatives transactions must be
marked to market and recorded somewhere in the financial statements.
T
F
26.
The objectives of end users of derivatives is the same as derivatives
dealers: use derivatives to make a profit.
T
F
27.
There are two distinct groups of specialists at derivatives dealer
institutions, sales personnel and traders.
Ade
r
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t
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28.
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.
253
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Effe
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29.
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r
.
254
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