Chap 025

Chapter 25 - Derivatives and Hedging Risk
Chapter 25
Derivatives and Hedging Risk
Multiple Choice Questions
1. A derivative is a financial instrument whose value is determined by:

A. a regulatory body such as the FTC.
B. a primitive or underlying asset.
C. hedging a risk.
D. hedging a speculation.
E. None of the above.
2. Derivatives can be used to either hedge or speculate. These actions:

A. increase risk in both cases.
B. decrease risk in both cases.
C. spread or minimize risk in both cases.
D. offset risk by hedging and increase risk by speculating.
E. offset risks by speculating and increase risk by hedging.
3. A forward contract is described by:

A. agreeing today to buy a product at a later date at a price to be set in the future.
B. agreeing today to buy a product today at its current price.
C. agreeing today to buy a product at a later date at a price set today.
D. agreeing today to buy a product if and only if its price rises above the exercise price today
at its current price.
4. The buyer of a forward contract:

A. will be taking delivery of the good(s) today at today's price.
B. will be making delivery of the good(s) at a later date at that date's price.
C. will be making delivery of the good(s) today at today's price.
D. will be taking delivery of the good(s) at a later date at pre-specified price.
E. Both A or D.
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5. The main difference between a forward contract and a cash transaction is:
A. only the cash transaction creates an obligation to perform.
B. a forward is performed at a later date while the cash transaction is performed immediately.
C. only one involves a deliverable instrument.
D. neither allows for hedging.
6. Futures contracts contrast with forward contracts by:

A. trading on an organized exchange.
B. marking to the market on a daily basis.
C. allowing the seller to deliver any day over the delivery month.
D. All of the above.
7. Which of the following is true about the user of derivatives?

A. Derivatives usually appear explicitly in the financial statements.
B. Academic surveys account for much of our knowledge of corporate derivatives use.
C. Smaller firms are more likely to use derivatives than large firms.
D. The most frequently used derivatives are commodity and equity futures.
E. None of the above are true.
8. Which of the following terms is not part of a forward contract?

A. Making delivery
B. Taking delivery
C. Delivery instrument
D. Cash transaction
9. Duration is a measure of the:

A. yield to maturity of a bond.
B. coupon yield of a bond.
C. price of a bond.
D. effective maturity of a bond.
E. All of the above.
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10. A swap is an arrangement for two counterparties to:

A. exchange cash flows over time.
B. permit fluctuation in interest rates.
C. help exchange markets clear.
11. LIBOR stands for:

A. Luasanne Interest Basis Offered Rate.
B. London International Offered Rate.
C. London Interbank Offered Rate.
D. London Interagency Offered Rate.
12. A futures contract on gold states that buyers and sellers agree to make or take delivery of
an ounce of gold for $400 per ounce. The contract expires in 3 months. The current price of
gold is $400 per ounce. If the price of gold rises and continues to rise every day over the 3
month period, then when the contract is settled, the buyer will _____ and the seller will
_____.
A. lose; gain
B. gain; lose
C. gain; break even
D. gain; gain
E. lose; lose
13. A potential disadvantage of forward contracts versus futures contracts is:

A. the extra liquidity required to cover the potential outflows that occur prior to delivery and
caused by marking to market.
B. the incentive for a particular party to default.
C. that the buyers and sellers don't know each other and never meet.
E. Both A and C.
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14. A farmer with wheat in the fields and who uses the futures market to protect a profit is an
example of:
A. a long hedge.
B. a short hedge.
C. selling futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
15. A miller who needs wheat to mill to flour uses the futures market to protect a profit by:
A. a long hedge to take delivery.
B. a short hedge to deliver.
C. buying futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
16. A chocolate company which uses the futures market to lock in the price of cocoa to
protect a profit is an example of:
A. a long hedge.
B. a short hedge.
C. purchasing futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
17. If the producer of a product has entered into a fixed price sale agreement for that output,
the producer faces:
A. a nice steady profit because the output price is fixed.
B. an uncertain profit if the input prices are volatile. This risk can be reduced by a short
hedge.
C. an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
D. a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
E. a modest profit if the input prices are stable. This risk can be reduced by a short hedge.
25-4
18. You hold a forward contract to take delivery of U.S. Treasury bonds in 9 months. If the
entire term structure of interest rates shifts down over the 9-month period, the value of the
forward contract will have _____ on the date of delivery.
A. risen
B. fallen
C. not changed
D. either risen or fallen, depending on the maturity of the T-bond
E. collapsed
19. Two key features of futures contracts that make them more in demand than forward
contracts are:
A. futures are traded on exchanges and must be marked to the market.
B. futures contracts allow flexibility in delivery dates and provide a liquid market for netting
positions.
C. futures are marked to the market and allow delivery flexibility.
D. futures are traded in liquid markets and are marked to the market.
20. If rates in the market fall between now and one month from now, the mortgage banker:
A. loses as the mortgages are sold at a discount.
B. gains as the mortgages are sold at a discount.
C. loses as the mortgages are sold at a premium.
D. gains as the mortgages are sold at a premium.
E. neither gains nor loses.
21. To protect against interest rate risk, the mortgage banker should:
A. buy futures, as this position will hedge losses if rates rise.
B. sell futures, as this position will hedge losses if rates rise.
C. sell futures, as this position will add to his gains if rates rise.
D. buy futures, as this position will add to his gains if rates rise.
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22. Futures market transactions are used to reduce risk. Risk may not be totally offset if:
A. the two instruments have different maturities.
B. payoff schedules of the two instruments are different.
C. the volatility of the two instruments are different.
D. the price movements are not perfectly correlated.
23. Hedging in the futures markets can reduce all risk if:
A. price movements in both the cash and futures markets are perfectly correlated.
B. price movements in both the cash and futures markets have zero correlation.
C. price movements in both the cash and futures markets are less than perfectly correlated.
D. the hedge is a short hedge, but not a long hedge.
E. the hedge is a long hedge, but not a short hedge.
24. Comparing long-term bonds with short-term bonds, long-term bonds are _____ volatile
and therefore experience _____ price change than short-term bonds for the same interest rate
shift.
A. less; less
B. less; more
C. more; more
D. more; less
E. more; the same
25. When interest rates shift, the price of zero coupon bonds:
A. are more volatile as compared with short-term bonds of the same maturity.
B. are less volatile as compared with short-term bonds of the same maturity.
C. are more volatile as compared with long-term bonds of the same maturity.
D. are less volatile as compared with long-term bonds of the same maturity.
E. Both A and C.
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26. Duration of a pure discount bond:

A. is equal to its half-life.
B. is less than a zero coupon bond.
C. is equal to the liabilities hedged.
D. is equal to its maturity.
27. In percentage terms, higher coupon bonds experience a _______ price change compared
with lower coupon bonds of the same maturity given a change in yield to maturity.
A. greater
B. smaller
C. similar
D. smaller or greater
28. A bond manager who wishes to hold the bond with the greatest potential volatility would
be wise to hold:
A. short-term, high-coupon bonds.
B. long-term, low-coupon bonds.
C. long-term, zero-coupon bonds.
D. short-term, zero-coupon bonds.
E. short-term, low-coupon bonds.
29. The duration of a 15 year zero coupon bond priced at $182.70 is:
A. 2.74 years.
B. 15 years.
C. 17.74 years.
D. cannot determine without the interest rate.
25-7
30. A set of bonds all have the same maturity. Which one has the least percentage price
change for given shifts in interest rates:
A. zero coupon bonds.
B. high coupon bonds.
C. low coupon bonds.
D. pure discount bonds.
E. not enough information to determine.
31. A financial institution can hedge its interest rate risk by:
A. matching the duration of its assets to the duration of its liabilities.
B. setting the duration of its assets equal to half that of the duration of its liabilities.
C. matching the duration of its assets, weighted by the market value of its assets with the
duration of its liabilities, weighted by the market value of its liabilities.
D. setting the duration of its assets, weighted by the market value of its assets to one half that
of the duration of the liabilities, weighted by the market value of the liabilities.
32. A pure discount bond pays:

A. no coupons, therefore its duration is equal to its maturity.
B. discounted coupons, therefore its duration is greater than its maturity.
C. level coupons, therefore its duration is equal to its maturity.
D. declining coupons, therefore its duration is less than its maturity.
33. Duration of a coupon paying bond is:

A. equal to its number of payments.
B. less than a zero coupon bond.
C. equal to the zero coupon bond.
D. equal to its maturity.
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34. A financial institution has equity equal to one-tenth of its assets. If its asset duration is
currently equal to its liability duration, then to immunize, the firm needs to:
A. decrease the duration of its assets.
B. increase the duration of its assets.
C. decrease the duration of its liabilities.
D. do nothing, i.e., keep the duration of its liabilities equal to the duration of its assets.
35. If a financial institution has equated the dollar effects of interest rate risk on its assets with
the dollar effects on its liabilities, it has engaged in:
A. a long hedge.
B. a short hedge.
C. a protected swap.
D. immunizing interest rate risk.
36. A savings and loan has extremely long-term assets that are currently matched against
extremely short-term liabilities. For this S&L:
A. falling interest rates will decrease the value of its equity.
B. falling interest rates will increase the value of its equity.
C. rising interest rates will increase the value of its equity.
D. rising interest rates will decrease the value of its equity.
E. Both B and D.
37. Interest rate and currency swaps allow one party to exchange a:
A. floating interest rate or currency value for a fixed value over the contract term.
B. fixed interest rate or currency value for a lower fixed value over the contract term.
C. floating interest rate or currency value for a lower floating value over the contract term.
D. fixed interest rate position for a currency position over the contract term.
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38. Exotic derivatives are complicated blends of other derivatives. Some exotics are:
A. inverse floaters.
B. cap and floors.
C. futures.
D. Both A and B.
E. Both B and C.
39. An inverse floater and a super-inverse floater are more valuable to a purchaser if:
A. interest rates stay the same.
B. interest rates fall.
C. interest rates rise.
D. held for a long time.
40. If a firm purchases a cap at 10% this will:

A. limit the amount of borrowing to 10% of assets.
B. pay the firm 10% on their purchase.
C. pay the holder the LIBOR interest above 10%.
D. pay the holder the LIBOR interest below the 10%.
41. If a firm sells a floor at 6% this will:

A. pay the holder the LIBOR interest below the 6%.
D. limit the amount of borrowing to 6% of assets.
42. In the practical use of credit default swaps there:

A. is not an organized exchange or template for the agreement.
B. is an organized exchange or template for the agreement.
C. are laws making them illegal in the United States.
D. are limits to the amount of borrowing of both parties.
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43. Credit default swaps:

A. will pay the holder the LIBOR interest rate.
B. pay the borrower the LIBOR interest rate.
C. are like insurance against a loss of value if the firm defaults on a bond.
D. limit the amount of borrowing of all parties in the credit default swap.
44. There are always ___ counterparties in a credit default swap:

A. 0
B. 1
C. 2
D. 3
E. more than three
45. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. You then decide to reverse your
position in the futures market on the fifth day at close. What is the net amount you receive at
the end of 5 days?
A. $0.00
B. $2.60
C. $2.70
D. $2.80
E. Must know the number of contracts
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. Before you can reverse your
position in the futures market on the fifth day you are notified to complete delivery. What will
you receive on delivery and what is the net amount you receive in total?
A. $2.60; $-0.10
B. $2.60; $0.10
C. $2.60; $2.70
D. $2.70; $-0.10
E. $2.70; $2.60
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47. You bought a futures contract for $2.60 per bushel and the contract ended at $2.70 after
several days of trading with the following close prices each day: $2.52, $2.57, $2.62, $2.68,
and $2.70. What would the mark to market sequence be?
A. -.08, .05, .05, .06, .02
B. .08, -.05, -.05, -.06, -.02
C. .08, .03, -.02, -.06, -.10
D. -.08, -.03, .02, .06, .10
E. .10, .06, .02, -.03, -.08
48. Suppose you agree to purchase one ounce of gold for $382 any time over the next month.
The current price of gold is $380. The spot price of gold then falls to $377 the next day. If the
agreement is represented by a futures contract marking to market on a daily basis as the price
changes, what is your cash flow at the end of the next business day?
A. $0
B. $3
C. $5
D. $-3
E. $-5
49. On March 1, you contract to take delivery of 1 ounce of gold for $415. The agreement is
good for any day up to April 1. Throughout March, the price of gold hit a low of $385 and hit
a high of $435. The price settled on March 31 at $420, and on April 1st you settle your futures
agreement at that price. Your net cash flow is:
A. $-30.
B. $-20.
C. $-15.
D. $5.
E. $20.
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50. A bank has a $50 million mortgage bond risk position which it hedges in the Treasury
bond futures markets at the Chicago Board of Trade. Approximately how many contracts are
needed to be held in the hedge?
A. 5
B. 50
C. 500
D. 5,000
E. 50,000
51. A mortgage banker had made loan commitments for $10 million in 3 months. How many
contracts on Treasury bonds futures must the banker write or buy?
A. Go short 10.
B. Go short 100.
C. Go long 10.
D. Go long 100.
52. The duration of a 2 year annual 10% bond that is selling for par is:
A. 1.00 years.
B. 1.91 years.
C. 2.00 years.
D. 2.09 years.
53. Firm A is paying $750,000 in interest payments a year while Firm B is paying LIBOR plus
75 basis points on $10,000,000 loans. The current LIBOR rate is 6.5%. Firm A and B have
agreed to swap interest payments. What is the net payment this year?
A. Firm A pays $750,000 to Firm B
B. Firm B pays $725,000 to Firm A
C. Firm B pays $25,000 to Firm A
D. Firm A pays $25,000 to Firm B
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54. A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent
annual coupon rate. The $1,000 face value is returned at maturity. If the effective annual yield
for all maturities is 7 percent annually, what is the current price of the Treasury note?
A. $960.68
B. $986.69
C. $1,010.35
D. $1,034.40
E. $1,038.99
55. Calculate the duration of a 7-year $1,000 zero-coupon bond with a current price of
$399.63 and a yield to maturity of 14%.
A. 5 years
B. 6 years
C. 7 years
D. 8 years
E. 9 years
56. Calculate the duration of a 4-year $1,000 face value bond, which pays 8% coupons
annually throughout maturity and has a yield to maturity of 9%.
A. 3.29 years
B. 3.57 years
C. 3.69 years
D. 3.89 years
E. 4.00 years
A. $-30.
B. $-20.
C. $-15.
D. $10.
E. $20.
25-14
A. 5
B. 80
C. 800
D. 8,000
E. 80,000
Essay Questions
59. Calculate the duration of Tiger State Bank's assets and liabilities.
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60. What new asset duration will immunize the balance sheet?
61. Duration is defined as the weighted average time to maturity of a financial instrument.
Explain how this knowledge can help protect against interest rate risk.
62. The futures markets are labeled as pure speculation and even gambling. Why is this an
inaccurate portrayal of the market's function?
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Chapter 25 Derivatives and Hedging Risk Answer Key
Multiple Choice Questions
1. A derivative is a financial instrument whose value is determined by:

A. a regulatory body such as the FTC.
B. a primitive or underlying asset.
C. hedging a risk.
D. hedging a speculation.
Difficulty level: Easy

Topic: DERIVATIVE
Type: DEFINITIONS
2. Derivatives can be used to either hedge or speculate. These actions:

A. increase risk in both cases.
B. decrease risk in both cases.
C. spread or minimize risk in both cases.
D. offset risk by hedging and increase risk by speculating.
E. offset risks by speculating and increase risk by hedging.
Difficulty level: Medium

Topic: HEDGING AND SPECULATING
Type: DEFINITIONS
25-17
3. A forward contract is described by:

A. agreeing today to buy a product at a later date at a price to be set in the future.
B. agreeing today to buy a product today at its current price.
C. agreeing today to buy a product at a later date at a price set today.
D. agreeing today to buy a product if and only if its price rises above the exercise price today
at its current price.

Topic: FORWARD CONTRACT
Type: DEFINITIONS
4. The buyer of a forward contract:

A. will be taking delivery of the good(s) today at today's price.
B. will be making delivery of the good(s) at a later date at that date's price.
C. will be making delivery of the good(s) today at today's price.
D. will be taking delivery of the good(s) at a later date at pre-specified price.
E. Both A or D.

Type: DEFINITIONS
5. The main difference between a forward contract and a cash transaction is:
A. only the cash transaction creates an obligation to perform.
B. a forward is performed at a later date while the cash transaction is performed immediately.
C. only one involves a deliverable instrument.
D. neither allows for hedging.

Type: DEFINITIONS
25-18
6. Futures contracts contrast with forward contracts by:

A. trading on an organized exchange.
B. marking to the market on a daily basis.
C. allowing the seller to deliver any day over the delivery month.

Topic: FUTURES AND FORWARDS
Type: DEFINITIONS
7. Which of the following is true about the user of derivatives?

A. Derivatives usually appear explicitly in the financial statements.
B. Academic surveys account for much of our knowledge of corporate derivatives use.
C. Smaller firms are more likely to use derivatives than large firms.
D. The most frequently used derivatives are commodity and equity futures.
E. None of the above are true.
Difficulty level: Challenge

Topic: EMPIRICAL STUDIES - DERIVATIVES
Type: DEFINITIONS
8. Which of the following terms is not part of a forward contract?

A. Making delivery
B. Taking delivery
C. Delivery instrument
D. Cash transaction

Type: DEFINITIONS
25-19
9. Duration is a measure of the:

A. yield to maturity of a bond.
B. coupon yield of a bond.
C. price of a bond.
D. effective maturity of a bond.

Topic: DURATION
Type: DEFINITIONS
10. A swap is an arrangement for two counterparties to:

A. exchange cash flows over time.
B. permit fluctuation in interest rates.
C. help exchange markets clear.

Topic: SWAP
Type: DEFINITIONS
11. LIBOR stands for:

A. Luasanne Interest Basis Offered Rate.
B. London International Offered Rate.
C. London Interbank Offered Rate.
D. London Interagency Offered Rate.

Topic: LIBOR
Type: DEFINITIONS
25-20
12. A futures contract on gold states that buyers and sellers agree to make or take delivery of
an ounce of gold for $400 per ounce. The contract expires in 3 months. The current price of
gold is $400 per ounce. If the price of gold rises and continues to rise every day over the 3
month period, then when the contract is settled, the buyer will _____ and the seller will
_____.
A. lose; gain
B. gain; lose
C. gain; break even
D. gain; gain
E. lose; lose

Topic: FUTURES
Type: CONCEPTS
13. A potential disadvantage of forward contracts versus futures contracts is:

A. the extra liquidity required to cover the potential outflows that occur prior to delivery and
caused by marking to market.
B. the incentive for a particular party to default.
C. that the buyers and sellers don't know each other and never meet.
E. Both A and C.

Topic: FORWARDS AND FUTURES
Type: CONCEPTS
14. A farmer with wheat in the fields and who uses the futures market to protect a profit is an
example of:
A. a long hedge.
B. a short hedge.
C. selling futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.

Topic: FUTURES
Type: CONCEPTS
25-21
15. A miller who needs wheat to mill to flour uses the futures market to protect a profit by:
A. a long hedge to take delivery.
B. a short hedge to deliver.
C. buying futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.

Topic: FUTURES
Type: CONCEPTS
16. A chocolate company which uses the futures market to lock in the price of cocoa to
protect a profit is an example of:
A. a long hedge.
B. a short hedge.
C. purchasing futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.

Topic: FUTURES
Type: CONCEPTS
17. If the producer of a product has entered into a fixed price sale agreement for that output,
the producer faces:
A. a nice steady profit because the output price is fixed.
B. an uncertain profit if the input prices are volatile. This risk can be reduced by a short
hedge.
C. an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
D. a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
E. a modest profit if the input prices are stable. This risk can be reduced by a short hedge.

Topic: HEDGING
Type: CONCEPTS
25-22
18. You hold a forward contract to take delivery of U.S. Treasury bonds in 9 months. If the
entire term structure of interest rates shifts down over the 9-month period, the value of the
forward contract will have _____ on the date of delivery.
A. risen
B. fallen
C. not changed
D. either risen or fallen, depending on the maturity of the T-bond
E. collapsed

Type: CONCEPTS
19. Two key features of futures contracts that make them more in demand than forward
contracts are:
A. futures are traded on exchanges and must be marked to the market.
B. futures contracts allow flexibility in delivery dates and provide a liquid market for netting
positions.
C. futures are marked to the market and allow delivery flexibility.
D. futures are traded in liquid markets and are marked to the market.

Topic: FUTURES AND FORWARDS
Type: CONCEPTS
20. If rates in the market fall between now and one month from now, the mortgage banker:
A. loses as the mortgages are sold at a discount.
B. gains as the mortgages are sold at a discount.
C. loses as the mortgages are sold at a premium.
D. gains as the mortgages are sold at a premium.
E. neither gains nor loses.

Topic: INTEREST RATE RISK
Type: CONCEPTS
25-23
21. To protect against interest rate risk, the mortgage banker should:
A. buy futures, as this position will hedge losses if rates rise.
B. sell futures, as this position will hedge losses if rates rise.
C. sell futures, as this position will add to his gains if rates rise.
D. buy futures, as this position will add to his gains if rates rise.

Type: CONCEPTS
22. Futures market transactions are used to reduce risk. Risk may not be totally offset if:
A. the two instruments have different maturities.
B. payoff schedules of the two instruments are different.
C. the volatility of the two instruments are different.
D. the price movements are not perfectly correlated.

Topic: RISK REDUCTION VIA FUTURES
Type: CONCEPTS
23. Hedging in the futures markets can reduce all risk if:
A. price movements in both the cash and futures markets are perfectly correlated.
B. price movements in both the cash and futures markets have zero correlation.
C. price movements in both the cash and futures markets are less than perfectly correlated.
D. the hedge is a short hedge, but not a long hedge.
E. the hedge is a long hedge, but not a short hedge.

Topic: HEDGING WITH FUTURES
Type: CONCEPTS
25-24
24. Comparing long-term bonds with short-term bonds, long-term bonds are _____ volatile
and therefore experience _____ price change than short-term bonds for the same interest rate
shift.
A. less; less
B. less; more
C. more; more
D. more; less
E. more; the same

Type: CONCEPTS
25. When interest rates shift, the price of zero coupon bonds:
A. are more volatile as compared with short-term bonds of the same maturity.
B. are less volatile as compared with short-term bonds of the same maturity.
C. are more volatile as compared with long-term bonds of the same maturity.
D. are less volatile as compared with long-term bonds of the same maturity.
E. Both A and C.

Type: CONCEPTS
26. Duration of a pure discount bond:

A. is equal to its half-life.
B. is less than a zero coupon bond.
C. is equal to the liabilities hedged.
D. is equal to its maturity.

Topic: DURATION
Type: CONCEPTS
25-25
27. In percentage terms, higher coupon bonds experience a _______ price change compared
with lower coupon bonds of the same maturity given a change in yield to maturity.
A. greater
B. smaller
C. similar
D. smaller or greater

Topic: PRICE AND INTEREST RATE RISK
Type: CONCEPTS
28. A bond manager who wishes to hold the bond with the greatest potential volatility would
be wise to hold:
A. short-term, high-coupon bonds.
B. long-term, low-coupon bonds.
C. long-term, zero-coupon bonds.
D. short-term, zero-coupon bonds.
E. short-term, low-coupon bonds.

Topic: VOLATILITY AND RISK
Type: CONCEPTS
29. The duration of a 15 year zero coupon bond priced at $182.70 is:
A. 2.74 years.
B. 15 years.
C. 17.74 years.
D. cannot determine without the interest rate.

Topic: DURATION
Type: CONCEPTS
25-26
30. A set of bonds all have the same maturity. Which one has the least percentage price
change for given shifts in interest rates:
A. zero coupon bonds.
B. high coupon bonds.
C. low coupon bonds.
D. pure discount bonds.
E. not enough information to determine.

Type: CONCEPTS
31. A financial institution can hedge its interest rate risk by:
A. matching the duration of its assets to the duration of its liabilities.
B. setting the duration of its assets equal to half that of the duration of its liabilities.
C. matching the duration of its assets, weighted by the market value of its assets with the
duration of its liabilities, weighted by the market value of its liabilities.
D. setting the duration of its assets, weighted by the market value of its assets to one half that
of the duration of the liabilities, weighted by the market value of the liabilities.

Type: CONCEPTS
32. A pure discount bond pays:

A. no coupons, therefore its duration is equal to its maturity.
B. discounted coupons, therefore its duration is greater than its maturity.
C. level coupons, therefore its duration is equal to its maturity.
D. declining coupons, therefore its duration is less than its maturity.

Topic: PURE DISCOUNT BOND
Type: CONCEPTS
25-27
33. Duration of a coupon paying bond is:

A. equal to its number of payments.
B. less than a zero coupon bond.
C. equal to the zero coupon bond.
D. equal to its maturity.

Topic: DURATION
Type: CONCEPTS
34. A financial institution has equity equal to one-tenth of its assets. If its asset duration is
currently equal to its liability duration, then to immunize, the firm needs to:
A. decrease the duration of its assets.
B. increase the duration of its assets.
C. decrease the duration of its liabilities.
D. do nothing, i.e., keep the duration of its liabilities equal to the duration of its assets.

Topic: IMMUNIZATION
Type: CONCEPTS
35. If a financial institution has equated the dollar effects of interest rate risk on its assets with
the dollar effects on its liabilities, it has engaged in:
A. a long hedge.
B. a short hedge.
C. a protected swap.
D. immunizing interest rate risk.

Topic: IMMUNIZATION
Type: CONCEPTS
25-28
36. A savings and loan has extremely long-term assets that are currently matched against
extremely short-term liabilities. For this S&L:
A. falling interest rates will decrease the value of its equity.
B. falling interest rates will increase the value of its equity.
C. rising interest rates will increase the value of its equity.
D. rising interest rates will decrease the value of its equity.
E. Both B and D.

Type: CONCEPTS
37. Interest rate and currency swaps allow one party to exchange a:
A. floating interest rate or currency value for a fixed value over the contract term.
B. fixed interest rate or currency value for a lower fixed value over the contract term.
C. floating interest rate or currency value for a lower floating value over the contract term.
D. fixed interest rate position for a currency position over the contract term.

Topic: RISK MANAGEMENT
Type: CONCEPTS
38. Exotic derivatives are complicated blends of other derivatives. Some exotics are:
A. inverse floaters.
B. cap and floors.
C. futures.
D. Both A and B.
E. Both B and C.

Topic: EXOTIC DERIVATIVES
Type: CONCEPTS
25-29
39. An inverse floater and a super-inverse floater are more valuable to a purchaser if:
A. interest rates stay the same.
B. interest rates fall.
C. interest rates rise.
D. held for a long time.

Topic: INVERSE FLOATER
Type: CONCEPTS
40. If a firm purchases a cap at 10% this will:

A. limit the amount of borrowing to 10% of assets.
D. pay the holder the LIBOR interest below the 10%.

Topic: LIBOR AND CAPS
Type: CONCEPTS
41. If a firm sells a floor at 6% this will:

A. pay the holder the LIBOR interest below the 6%.
D. limit the amount of borrowing to 6% of assets.

Topic: LIBOR AND FLOORS
Type: CONCEPTS
25-30
42. In the practical use of credit default swaps there:

A. is not an organized exchange or template for the agreement.
B. is an organized exchange or template for the agreement.
C. are laws making them illegal in the United States.
D. are limits to the amount of borrowing of both parties.

Topic: CREDIT DEFAULT SWAPS (CDS)
Type: CONCEPTS
43. Credit default swaps:

A. will pay the holder the LIBOR interest rate.
B. pay the borrower the LIBOR interest rate.
C. are like insurance against a loss of value if the firm defaults on a bond.
D. limit the amount of borrowing of all parties in the credit default swap.

Type: CONCEPTS
44. There are always ___ counterparties in a credit default swap:

A. 0
B. 1
C. 2
D. 3
E. more than three

Type: CONCEPTS
25-31
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. You then decide to reverse your
position in the futures market on the fifth day at close. What is the net amount you receive at
the end of 5 days?
A. $0.00
B. $2.60
C. $2.70
D. $2.80
E. Must know the number of contracts
Contract nets to you the original price. The net position is based on daily marking to the
market. The net change is $- .10, Close - Change = $2.70 -$10 = $2.60

Topic: FUTURES AND PROCEEDS
Type: PROBLEMS
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. Before you can reverse your
position in the futures market on the fifth day you are notified to complete delivery. What will
you receive on delivery and what is the net amount you receive in total?
A. $2.60; $-0.10
B. $2.60; $0.10
C. $2.60; $2.70
D. $2.70; $-0.10
E. $2.70; $2.60
Delivery is made at the settle price of $2.70. The net position is based on daily marking to the
market. The difference of -.10 = (.08 + -.05 + -.05 + -.06 + - .02), which is a loss versus the
last settle price.

Topic: FUTURES AND PROCEEDS
Type: PROBLEMS
25-32
47. You bought a futures contract for $2.60 per bushel and the contract ended at $2.70 after
several days of trading with the following close prices each day: $2.52, $2.57, $2.62, $2.68,
and $2.70. What would the mark to market sequence be?
A. -.08, .05, .05, .06, .02
B. .08, -.05, -.05, -.06, -.02
C. .08, .03, -.02, -.06, -.10
D. -.08, -.03, .02, .06, .10
E. .10, .06, .02, -.03, -.08
Daily marking to the market from prior day settle.

($2.52 - $2.60; $2.57 - $2.52; $2.62 - $2.57; $2.68 - $2.62; $2.70 - $2.68) = ($-.08; $.05; $.05;
$.06; $.02)

Topic: MARK TO MARKET
Type: PROBLEMS
48. Suppose you agree to purchase one ounce of gold for $382 any time over the next month.
The current price of gold is $380. The spot price of gold then falls to $377 the next day. If the
agreement is represented by a futures contract marking to market on a daily basis as the price
changes, what is your cash flow at the end of the next business day?
A. $0
B. $3
C. $5
D. $-3
E. $-5
Futures Position = Spot = $377 - $380 = $-3

Topic: FUTURES AND CASH FLOW
Type: PROBLEMS
25-33
A. $-30.
B. $-20.
C. $-15.
D. $5.
E. $20.
NCF = $420 - $415 = $5

Type: PROBLEMS
A. 5
B. 50
C. 500
D. 5,000
E. 50,000
Portfolio Value/TB and Contract Value = $50,000,000/$100,000 = 500

Topic: FUTURES CONTRACTS
Type: PROBLEMS
25-34
51. A mortgage banker had made loan commitments for $10 million in 3 months. How many
contracts on Treasury bonds futures must the banker write or buy?
A. Go short 10.
B. Go short 100.
C. Go long 10.
D. Go long 100.
Must write/go short = $10,000,000/$100,000 = 100

Topic: TREASURY BOND FUTURES
Type: PROBLEMS
52. The duration of a 2 year annual 10% bond that is selling for par is:
A. 1.00 years.
B. 1.91 years.
C. 2.00 years.
D. 2.09 years.
D = 1[(100/1.1)]/1000 + 2[(1100/1.12)]/1000 = .09091 + 1.81818 = 1.90909 = 1.91 years

Topic: DURATION
Type: PROBLEMS
25-35
53. Firm A is paying $750,000 in interest payments a year while Firm B is paying LIBOR plus
75 basis points on $10,000,000 loans. The current LIBOR rate is 6.5%. Firm A and B have
agreed to swap interest payments. What is the net payment this year?
A. Firm A pays $750,000 to Firm B
B. Firm B pays $725,000 to Firm A
C. Firm B pays $25,000 to Firm A
D. Firm A pays $25,000 to Firm B
Firm A pays a fixed payment of $750,000 to B in exchange for the floating payment of (.065
+ .0075) 10,000,000 = 725,000. The net position is that Firm A pays $25,000 to Firm B.

Topic: SWAPS
Type: PROBLEMS
54. A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent
annual coupon rate. The $1,000 face value is returned at maturity. If the effective annual yield
for all maturities is 7 percent annually, what is the current price of the Treasury note?
A. $960.68
B. $986.69
C. $1,010.35
D. $1,034.40
E. $1,038.99
The semi-annual spot rates are (1.07.5) = 1.0344

P = 45 A4,3.44+ 10454,3.44PV = $1,038.99

Topic: NOTE PRICE
Type: PROBLEMS
25-36
55. Calculate the duration of a 7-year $1,000 zero-coupon bond with a current price of
$399.63 and a yield to maturity of 14%.
A. 5 years
B. 6 years
C. 7 years
D. 8 years
E. 9 years
Duration of a zero is always equal to its maturity = 7 years.

Topic: DURATION
Type: PROBLEMS
56. Calculate the duration of a 4-year $1,000 face value bond, which pays 8% coupons
annually throughout maturity and has a yield to maturity of 9%.
A. 3.29 years
B. 3.57 years
C. 3.69 years
D. 3.89 years
E. 4.00 years
D = [80/(1.09 + 160)/(1.09)2+ 240/(1.09)3+ 4,320/(1.09)4]/967.60 = 3453.78/967.60 = 3.569

years.

Topic: DURATION
Type: PROBLEMS
25-37
A. $-30.
B. $-20.
C. $-15.
D. $10.
E. $20.
NCF = $505 - $495 = $10

Type: PROBLEMS
A. 5
B. 80
C. 800
D. 8,000
E. 80,000
Portfolio Value/TB and Contract Value = $80,000,000/$100,000 = 800

Topic: FUTURES CONTRACTS
Type: PROBLEMS
Essay Questions
25-38
59. Calculate the duration of Tiger State Bank's assets and liabilities.
DA = (3/39)(0) + (8/39)(.6) + (20/39)(2.2) + (8/39)(7.5) = 2.79 years

DL = (20/36)(0) + (4/36)(.4) + (12/36)(3.2) = 1.111 years
Topic: DURATION
Type: ESSAYS
60. What new asset duration will immunize the balance sheet?
Given DL = 1.111(see #55 above), then DA 39 = 1.111(36); DA = 1.0255 years
Topic: DURATION
Type: ESSAYS
25-39
61. Duration is defined as the weighted average time to maturity of a financial instrument.
Explain how this knowledge can help protect against interest rate risk.
Duration measures effective time to recoup your investment. Bond prices rise and fall with
interest rate changes. There are two elements of risk. The first being reinvestment risk--may
earn less $ when reinvesting, and the second being price. The value of the bond moves
inversely with interest rates. By setting duration equal to holding horizon, reinvestment and
price risk offset each other. By setting duration of assets equal to duration of liabilities, both
move up and down together.
Topic: DURATION
Type: ESSAYS
62. The futures markets are labeled as pure speculation and even gambling. Why is this an
inaccurate portrayal of the market's function?
There are several reasons:

The market sets (discovers) prices for assets;
Future positions are for performance at a later date, not a spot transaction;
Earnest money as margin based on performance;
Speculators bear risk for hedgers; and
Hedgers are spreading/reducing their risk.
Therefore, the market is zero-sum game and positions can be netted easily and marking to
market takes place daily.
Topic: FUTURES MARKETS

Type: ESSAYS
25-40

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Chapter 25 - Derivatives and Hedging Risk

Multiple Choice Questions

1. A derivative is a financial instrument whose value is determined by:

2. Derivatives can be used to either hedge or speculate. These actions:

3. A forward contract is described by:

4. The buyer of a forward contract:

6. Futures contracts contrast with forward contracts by:

7. Which of the following is true about the user of derivatives?

8. Which of the following terms is not part of a forward contract?

9. Duration is a measure of the:

10. A swap is an arrangement for two counterparties to:

11. LIBOR stands for:

13. A potential disadvantage of forward contracts versus futures contracts is:

26. Duration of a pure discount bond:

32. A pure discount bond pays:

33. Duration of a coupon paying bond is:

40. If a firm purchases a cap at 10% this will:

41. If a firm sells a floor at 6% this will:

42. In the practical use of credit default swaps there:

43. Credit default swaps:

44. There are always ___ counterparties in a credit default swap:

Chapter 25 Derivatives and Hedging Risk Answer Key

Multiple Choice Questions

1. A derivative is a financial instrument whose value is determined by:

Difficulty level: Easy

2. Derivatives can be used to either hedge or speculate. These actions:

Difficulty level: Medium

3. A forward contract is described by:

Difficulty level: Easy

4. The buyer of a forward contract:

Difficulty level: Medium

Difficulty level: Medium

6. Futures contracts contrast with forward contracts by:

Difficulty level: Easy

7. Which of the following is true about the user of derivatives?

Difficulty level: Challenge

8. Which of the following terms is not part of a forward contract?

Difficulty level: Easy

9. Duration is a measure of the:

Difficulty level: Easy

10. A swap is an arrangement for two counterparties to:

Difficulty level: Easy

11. LIBOR stands for:

Difficulty level: Easy

Difficulty level: Easy

13. A potential disadvantage of forward contracts versus futures contracts is:

Difficulty level: Easy

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Challenge

Difficulty level: Challenge

Difficulty level: Easy

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

26. Duration of a pure discount bond:

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Medium

Difficulty level: Easy