Ch23 Test Bank 4-5-10

CHAPTER 23 DERIVATIVES AND RISK MANAGEMENT Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.

True/False Easy: 1

.

(23.1) Risk management FP Answer: a EASY One objective of risk management can be to reduce the volatility of a firm’s cash flows. a. True b. False (23.4) Swaps

2

.

FP

Answer: b

EASY

Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses. a. True b. False

3

.

(23.5) Speculative versus pure risk FP Answer: a EASY Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses. a. True b. False

4

.

(23.6) Risk management FP Answer: b In theory, reducing the volatility of its cash flows will always increase a company’s value.

EASY

a. True b. False

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Chapter 23: Derivatives

True/False

Page 1

Medium: 5

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(23.6) Futures market hedging FP Answer: b MEDIUM The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills. a. True b. False

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Page 2

True/False

Chapter 23: Derivatives

Multiple Choice: Conceptual Medium: 6

.

(23.1) Risk management CP Answer: e MEDIUM Which of the following are NOT ways risk management can be used to increase the value of a firm? a. b. c. d. e.

7

.

Risk management can increase debt capacity. Risk management can help a firm maintain its optimal capital budget. Risk management can reduce the expected costs of financial distress. Risk management can help firms minimize taxes. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

(23.1) Interest rate and reinvestment rate risk CP Answer: b MEDIUM Which of the following statements about interest rate and reinvestment rate risk is CORRECT? a. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities. b. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested. c. Interest rate price risk can be eliminated by holding zero coupon bonds. d. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds. e. Interest rate risk can never be reduced.

8

.

(23.4) Swaps CP Answer: d A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?

MEDIUM

a. A swap involves the exchange of cash payment obligations. b. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds. c. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties. d. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market. e. A company can swap fixed interest payments for floating interest payments.

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Chapter 23: Derivatives

Conceptual Questions

Page 3

9

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(23.4) Forwards vs. futures CP Which of the following statements is most CORRECT?

Answer: b

MEDIUM

a. One advantage of forward contracts is that they are default free. b. Futures contracts generally trade on an organized exchange and are marked to market daily. c. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts. d. There are futures contracts for currencies but no forward contracts for currencies. e. Futures contracts don’t have any margin requirements but forward contracts do.

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Page 4

Conceptual Questions

Chapter 23: Derivatives

10

.

(23.6) Hedging CP Answer: d MEDIUM A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates? a. Buying inverse floaters. b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates. c. Purchase principal only (PO) strips that decline in value whenever interest rates rise. d. Enter into a short hedge where the bank agrees to sell interest rate futures. e. Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.

Multiple Choice: Problems Medium: 11

.

(23.4) Swaps—nonalgorithmic CP Answer: b MEDIUM Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B? a. b. c. d. e.

12

.

A pays a fixed rate of 9%, B pays LIBOR + 1.5%. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%. A pays a fixed rate of 7.95%, B pays LIBOR. None of the above answers is correct.

(23.6) Treasury bond futures contracts CP Answer: c MEDIUM Suppose the September CBOT Treasury bond futures contract has a quoted price of 89-09. What is the implied annual interest rate inherent in this futures contract? a. b. c. d. e.

6.32% 6.65% 7.00% 7.35% 7.72%

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Chapter 23: Derivatives

Problems

Page 5

13

.

(23.6) Treasury bond futures contracts CP Answer: d MEDIUM Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. What is the implied annual interest rate inherent in the futures contract? a. b. c. d. e.

14

.

6.86% 7.22% 7.60% 8.00% 8.40%

(23.6) Treasury bond futures contracts CP Answer: a MEDIUM Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the nearest whole dollar.) a. b. c. d. e.

-$78.00 -$82.00 -$86.00 -$90.00 -$95.00

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Page 6

Problems

Chapter 23: Derivatives

CHAPTER 23 ANSWERS AND SOLUTIONS

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Chapter 23: Derivatives

Answers

Page 7

1

.

(23.1) Risk management

FP Answer: a

2.

(23.4) Swaps

FP Answer: b

EASY

3.

(23.5) Speculative versus pure risk

FP Answer: a

EASY

4.

(23.6) Risk management

FP Answer: b

EASY

5.

(23.6) Futures market hedging

FP Answer: b

MEDIUM

6

.

7.

(23.1) Interest rate and reinvestment rate risk

8.

(23.4) Swaps

CP Answer: d

MEDIUM

9.

(23.4) Forwards vs. futures

CP Answer: b

MEDIUM

10.

(23.6) Hedging

CP Answer: d

MEDIUM

(23.1) Risk management

CP Answer: e

EASY

CP

MEDIUM

Answer: b

MEDIUM

Given its interest rate exposure, the bank needs a strategy which is profitable whenever interest rates rise. If designed correctly, the profits from this strategy can partially, or in some cases, completely offset the losses the bank realizes from its basic operations whenever rates rise. Of the 5 strategies, only the short hedge is profitable when rates rise--all the other strategies would make sense if the bank were looking for extra profits when rates dropped. 11.

(23.4) Swaps—nonalgorithmic

CP Answer: b

MEDIUM

A pays LIBOR + 1% to its lenders, receives LIBOR from B, and pays B 7.95%, for a net fixed payment of 8.95%. B pays 9.4% to its lenders, pays LIBOR to A, and receives 7.95% from A, for a net payment of LIBOR + 1.45%. 12.

(23.6) Treasury bond futures contracts Quote:

89-09

0.89

CP

Answer: c

MEDIUM

0.09

N: 40 PV = (0.89 + .09/32) × $1,000 = -$892.8125 FV = $1,000 PMT = $30 I/YR = 3.50% Annual rate: I/YR × 2 = 7.00% 13.

(23.6) Treasury bond futures contracts Quote:

80-07

0.80

CP

Answer: d

MEDIUM

Answer: a

MEDIUM

0.07

N: 40 PV = (0.80+0.07/32) × $1,000 = -$802.1875 FV = $1,000 PMT = $30 I/YR = 4.00% Annual rate: I/YR × 2 = 8.00% 14.

(23.6) Treasury bond futures contracts Quote:

80-07

0.80

0.07

CP

Increase in annual rate: 0.01000 Par value: $1,000 N: 40 PMT: $30 Price = PV = (0.80+0.07/32) × $1,000 = -$802.1875 Enter data to get rate = I/YR 2 = 7.9986% New rate = (Old rate + 1.0%)/2 = 4.4993% New price = -$724.08 Change in price = loss = -$78