Chap026.pdf

Chapter 26 - Managing Risk

Chapter 26 Managing Risk Multiple Choice Questions

1. Ideally, hedging transactions are: A. Negative NPV transactions B. Positive NPV transactions C. Zero-NPV transactions D. None of the above

2. When a firm hedges a risk it is: A. eliminating the risk B. transferring risk to someone else C. making the government assume the risk D. none of the above

3. Investors' do-it-yourself alternative to hedging is: A. investing in a single stock B. diversification C. borrowing and investing in a single stock D. none of the above

4. The following are the reasons for firms to undertake risk-reducing transactions is practice: I) reduce the risk of financial distress II) reduce the fluctuations in its income III) mitigate agency costs A. I only B. I and II only C. I, II and III D. II and III only

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5. In addition to the cost of bearing risk, insurance companies also bear: I) Administrative costs II) Moral hazard costs III) Adverse selection costs A. I only B. II only C. III only D. I, II, and III

6. The risk manager needs to come up with answers to the following questions: I) what are the major risks that the company is facing and what are the possible consequences? II) is the company being paid for taking these risks? III) should we worry about risk at all as risk is God-given? IV) how should risks be controlled? A. I only B. I and II only C. I, II and IV only D. III only

7. Insurance companies have some advantages in bearing risk; these include: I) Superior ability to estimate the probability of loss II) Extensive experience and knowledge about how to reduce the risk of a loss III) The ability to pool risks and thereby gain from diversification IV) Insurance companies cannot diversify away market or macroeconomic risks A. I, II, and III only B. II only C. III only D. IV only

8. Insurance companies face the following problems? A. Administrative costs B. Adverse selection C. Moral hazard D. all of the above

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9. Insurance companies, by issuing Cat bonds (catastrophe bonds) are sharing their risks with: I) The government II) Other insurance companies III) The investors A. I only B. II only C. III only D. I and II only

10. The term "Derivatives" refers to: I) Forwards II) Futures III) Swaps IV) Option A. I and II only B. I, II, and III only C. III and IV only D. I, II, III, and IV

11. A derivative is a financial instrument whose value is determined by: A. a regulatory body such as the FTC B. the value of an underlying asset C. hedging a risk D. speculation

12. Derivatives can be used either to hedge or to 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

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13. 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

14. The seller of a forward contract: A. agrees to deliver a product at a later date for a price set today B. agrees to receive a product at a later date at the price on that later date C. agrees to receive a product at a later date for a price set today D. agrees to deliver a product at a later date for a price set on that later date

15. The price for immediate delivery is called: A. forward price B. exercise price C. spot price D. none of the above

16. The type of risk associated with a forward contract is called: A. market risk B. default risk C. currency risk D. counterparty risk

17. When a standardized forward contract is traded on an exchange, it is called: A. forward contract B. futures contract C. options contract D. none of the above

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18. The following futures contracts are traded on the Chicago Board of Trade (CBOT): I) U.S. Treasury bonds II) German government bonds (bunds) III) Swaps IV) U.S. Treasury bills A. I only B. I and II only C. I, II and III only D. IV only

19. The following futures contracts are traded on the Chicago Mercantile Exchange (CME): I) U.S. Treasury bonds II) S&P 500 Index III) Euro IV) U.S. Treasury bills A. I only B. II, III and IV only C. II and III only D. IV only

20. If you sold a wheat futures contract for $3.75 per bushel and the contract ended at $3.60, how much will you net per bushel? (Ignore transaction costs.) A. $3.75 B. $0.15 C. $3.60 D. None of the above

21. If you sold a futures contract for $3.75 per bushel and the contract ended at $3.60 after several days of trading of $3.80, $3.70, $3.65, $3.70, $3.65 and $3.60. What would the mark to market sequence be? A. -0.05, 0.10, 0.05, -0.05, 0.05, 0.05 B. 0.05, -0.10, -0.05, 0.05, -0.05, -0.05 C. -0.05, 0.05, 0.10, 0.05, -0.09, -0.15 D. 0.05, -0.05, -0.10, -0.05, -0.09, -0.015

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22. If you bought eight contracts of Euro currency futures (i.e. total of one million Euros) with an initial margin of $2835 per contract. You buy the contracts at $1.3468/Euro and after a few days of trading ends at a price of $1.3534/Euro with the following ending price each day: $1.3465, $1.3443, $1.3434 and $1.3534. What would be the margin account value sequence be? Starting value being $22,680 (i.e. 8 * 2835 = $22,680). A. $22,680, $22,180, $20,380, $19,280, $29,280 B. $22,680, $22,380, $20,180, $19,280, $29,280 C. $22,680, $22,180, $19,280, $22,380, $29,280 D. none of the above

23. Futures trading eliminates: A. market risk B. counterparty risk C. default risk D. none of the above

24. The current level of Standard & Poor's index is 500. The prospective dividend yield is 2%, and the interest rate is 6%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.) A. 530 B. 520 C. 540 D. None of the above

25. The relationship between the spot and futures prices of financial futures is given by: A. [Futures price] = Spot price(1 + rf)^t (where rf = risk-free rate) B. [Futures price] = Spot price (1 + rf - y)^t (where y = dividend yield or interest rate) C. [Futures price] = Spot price (1 + rm)^t (where rm = market rate of return) D. None of the above

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26. The current level of Standard and Poor's index is 950. The prospective dividend yield is 3%, and the interest rate is 5%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.) A. 969 B. 997.5 C. 978.5 D. None of the above

27. The current level of S & P 500 index is 1100. The prospective dividend yield is 3%, and the current interest rate is 7%. What is the value of a one-year futures contract on the index? (Assume all dividends are paid at the end of the year.) A. 1177 B. 1144 C. 1133 D. None of the above

28. The spot price of wheat is $2.90/bushel. One year futures price is $3.00/bushel. If the riskfree rate is 5%, calculate the net convenience yield. A. -0.019 B. +0.019 C. +0.0345 D. None of the above

29. The spot price for delivery of home heating oil is $0.55 per gallon. The futures price for one year from now is $0.57. If the risk-free rate is 6% per year, what is the net convenience yield? A. 0.0411 B. 0.0364 C. 0.0236 D. 0.044

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30. A forward interest rate contract is called a A. Forward contract B. Forward Rate Agreement C. Futures Rate Agreement D. None of the above

31. If the one-year spot interest rate is 6% and two-year spot interest rate is 7%, calculate the one-year forward interest rate one year from today (approximately): A. 6% B. 7% C. 8% D. None of the above

32. If the one-year spot interest rate is 8% and two-year spot interest rate is 9%, calculate the one-year forward interest rate one year from today (approximately): A. 10% B. 12% C. 14% D. None of the above

33. Suppose you borrow $95.24 for one year at 5% and invest $95.24 for two years at 7%. For the time period beginning one year from today, you have: (approximately) A. Borrowed at 7% B. Invested at 7% C. Borrowed at 9% D. Invested at 9%

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34. First National Bank has made a 5-year, $100 million fixed-rate loan at 10%. Annual interest payments are $10 million, and all principal will be repaid in year 5. The bank wants to swap the fixed interest payment into floating-rate payments. If the bank could borrow at a fixed rate of 8% for 5 years, what is the notional principal of the swap? A. $80 million B. $100 million C. $125 million D. $180 million

35. Third National Bank has made 10-year, $25 million fixed-rate loan at 12%. Annual interest payments are $3 million, and all principal will be repaid in year 10. The bank wants to swap the fixed interest payments into floating-rate payments. If the bank could borrow at a fixed rate of 10% for 10 years, what is the notional principal of the swap? A. $40 million B. $20 million C. $25 million D. $30 million

36. Firm A is paying a fixed $700,000 in interest payments, while Firm B is paying LIBOR plus 50 basis points on $10,000,000 loans. The current LIBOR rate is 6.25%. Firm A and B have agreed to swap interest payments, how much will be paid to which Firm this year? A. A pays $750,000 to Firm B B. B pays 25,000 to Firm A C. B pays $50,000 to Firm A D. A pays $25,000 to Firm B

37. In a "total return swap" the asset might be a: I) common stock II) loan III) commodity IV) market index A. I and II only B. I, II and III only C. I, II, III and IV D. IV only

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Chapter 26 - Managing Risk

38. Banks that have a portfolio of loans generally hedge against default of loans by: A. negotiating default swap on each individual loan B. buying credit option on each individual loan C. negotiate a portfolio default swap, which provides protection on the entire portfolio D. none of the above

39. A firm owns an asset A and it wants to hedge against changes in the value of A by making an offsetting sale of asset B. The firm minimizes risk if: A. Selling the same number of units of B as assets of A B. Selling hedge ratio (delta) number of units of B C. Selling the reciprocal of hedge ratio number of units of B D. None of the above

40. 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. Match 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

41. Four investors enter into long sugar contracts. Three are speculators and one is hedging. Which of the following is hedging? A. Farmer B. Cereal company C. Mutual fund D. None of the above

42. What investment would be a hedge for a corn farmer? A. Long corn put option B. Long corn call option C. Long corn futures D. None of the above

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True / False Questions

43. Disadvantages faced by insurance companies in bearing risk are: administrative costs, adverse selection and moral hazard. True False

44. Derivative instruments are those whose value depends on the value of another asset. True False

45. Options contracts are marked to market. True False

46. "Mark to market" means that each day any profits or losses are calculated and your account is adjusted accordingly. True False

47. For commodity futures: (Futures price)(1 + rf)^t = Spot price-net convenience yield. True False

48. Convenience yield is the extra value created by holding the actual commodity rather than a financial claim on it. True False

49. For financial futures, (Spot price)/(1 + rf - y)^t = Futures price. True False

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50. For commodity futures, net convenience yield = (convenience yield - storage costs). True False

51. A company that wishes to lock in an interest rate on future borrowing can either enters into a FRA or it can borrow long-term funds and lend short-term. True False

52. If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 7.5% which is the average of the two rates. True False

53. If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 9%. True False

54. Hedge ratio or delta measures the sensitivity of the value of one asset relative to the value of another asset. True False

55. Hedging requires an offsetting position. True False

56. In a rising market, more derivatives investors will make money than lose money. True False

Short Answer Questions

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Chapter 26 - Managing Risk

57. What are the disadvantages faced by the insurance companies in bearing risk?

58. Briefly explain the term "derivatives."

59. What are the four basic types of contracts or instruments used in financial risk management?

60. Are companies that trade in derivatives speculating?

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Chapter 26 - Managing Risk

61. Briefly explain the term "marked to market."

62. Briefly explain the mechanics of homemade forward rate agreements.

63. Briefly explain swaps.

64. Explain how a firm wishing to invest in floating rate investments can use a swap to manage its interest rate exposure?

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65. Briefly explain how options can be used for hedging.

66. What is the difference between hedging, speculation, and arbitrage?

67. Why are derivatives necessary for a thriving economy?

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Chapter 26 - Managing Risk

Chapter 26 Managing Risk Answer Key

Multiple Choice Questions

1. Ideally, hedging transactions are: A. Negative NPV transactions B. Positive NPV transactions C. Zero-NPV transactions D. None of the above

Type: Easy

2. When a firm hedges a risk it is: A. eliminating the risk B. transferring risk to someone else C. making the government assume the risk D. none of the above

Type: Medium

3. Investors' do-it-yourself alternative to hedging is: A. investing in a single stock B. diversification C. borrowing and investing in a single stock D. none of the above

Type: Medium

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4. The following are the reasons for firms to undertake risk-reducing transactions is practice: I) reduce the risk of financial distress II) reduce the fluctuations in its income III) mitigate agency costs A. I only B. I and II only C. I, II and III D. II and III only

Type: Medium

5. In addition to the cost of bearing risk, insurance companies also bear: I) Administrative costs II) Moral hazard costs III) Adverse selection costs A. I only B. II only C. III only D. I, II, and III

Type: Easy

6. The risk manager needs to come up with answers to the following questions: I) what are the major risks that the company is facing and what are the possible consequences? II) is the company being paid for taking these risks? III) should we worry about risk at all as risk is God-given? IV) how should risks be controlled? A. I only B. I and II only C. I, II and IV only D. III only

Type: Medium

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7. Insurance companies have some advantages in bearing risk; these include: I) Superior ability to estimate the probability of loss II) Extensive experience and knowledge about how to reduce the risk of a loss III) The ability to pool risks and thereby gain from diversification IV) Insurance companies cannot diversify away market or macroeconomic risks A. I, II, and III only B. II only C. III only D. IV only

Type: Easy

8. Insurance companies face the following problems? A. Administrative costs B. Adverse selection C. Moral hazard D. all of the above

Type: Easy

9. Insurance companies, by issuing Cat bonds (catastrophe bonds) are sharing their risks with: I) The government II) Other insurance companies III) The investors A. I only B. II only C. III only D. I and II only

Type: Easy

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10. The term "Derivatives" refers to: I) Forwards II) Futures III) Swaps IV) Option A. I and II only B. I, II, and III only C. III and IV only D. I, II, III, and IV

Type: Medium

11. A derivative is a financial instrument whose value is determined by: A. a regulatory body such as the FTC B. the value of an underlying asset C. hedging a risk D. speculation

Type: Medium

12. Derivatives can be used either to hedge or to 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

Type: Medium

13. 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

Type: Medium

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14. The seller of a forward contract: A. agrees to deliver a product at a later date for a price set today B. agrees to receive a product at a later date at the price on that later date C. agrees to receive a product at a later date for a price set today D. agrees to deliver a product at a later date for a price set on that later date

Type: Medium

15. The price for immediate delivery is called: A. forward price B. exercise price C. spot price D. none of the above

Type: Easy

16. The type of risk associated with a forward contract is called: A. market risk B. default risk C. currency risk D. counterparty risk

Type: Medium

17. When a standardized forward contract is traded on an exchange, it is called: A. forward contract B. futures contract C. options contract D. none of the above

Type: Easy

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18. The following futures contracts are traded on the Chicago Board of Trade (CBOT): I) U.S. Treasury bonds II) German government bonds (bunds) III) Swaps IV) U.S. Treasury bills A. I only B. I and II only C. I, II and III only D. IV only

Type: Difficult

19. The following futures contracts are traded on the Chicago Mercantile Exchange (CME): I) U.S. Treasury bonds II) S&P 500 Index III) Euro IV) U.S. Treasury bills A. I only B. II, III and IV only C. II and III only D. IV only

Type: Difficult

20. If you sold a wheat futures contract for $3.75 per bushel and the contract ended at $3.60, how much will you net per bushel? (Ignore transaction costs.) A. $3.75 B. $0.15 C. $3.60 D. None of the above Sell at $3.75 and buy back at $3.60; net profit = 0.15/bushel

Type: Medium

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21. If you sold a futures contract for $3.75 per bushel and the contract ended at $3.60 after several days of trading of $3.80, $3.70, $3.65, $3.70, $3.65 and $3.60. What would the mark to market sequence be? A. -0.05, 0.10, 0.05, -0.05, 0.05, 0.05 B. 0.05, -0.10, -0.05, 0.05, -0.05, -0.05 C. -0.05, 0.05, 0.10, 0.05, -0.09, -0.15 D. 0.05, -0.05, -0.10, -0.05, -0.09, -0.015

Type: Difficult

22. If you bought eight contracts of Euro currency futures (i.e. total of one million Euros) with an initial margin of $2835 per contract. You buy the contracts at $1.3468/Euro and after a few days of trading ends at a price of $1.3534/Euro with the following ending price each day: $1.3465, $1.3443, $1.3434 and $1.3534. What would be the margin account value sequence be? Starting value being $22,680 (i.e. 8 * 2835 = $22,680). A. $22,680, $22,180, $20,380, $19,280, $29,280 B. $22,680, $22,380, $20,180, $19,280, $29,280 C. $22,680, $22,180, $19,280, $22,380, $29,280 D. none of the above

Type: Difficult

23. Futures trading eliminates: A. market risk B. counterparty risk C. default risk D. none of the above

Type: Medium

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24. The current level of Standard & Poor's index is 500. The prospective dividend yield is 2%, and the interest rate is 6%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.) A. 530 B. 520 C. 540 D. None of the above Futures price = 500(1 + 0.06 - 0.02) = 520

Type: Difficult

25. The relationship between the spot and futures prices of financial futures is given by: A. [Futures price] = Spot price(1 + rf)^t (where rf = risk-free rate) B. [Futures price] = Spot price (1 + rf - y)^t (where y = dividend yield or interest rate) C. [Futures price] = Spot price (1 + rm)^t (where rm = market rate of return) D. None of the above

Type: Medium

26. The current level of Standard and Poor's index is 950. The prospective dividend yield is 3%, and the interest rate is 5%. What is the value of a one-year futures contract on the index? (Assume all dividend payments occur at the end of the year.) A. 969 B. 997.5 C. 978.5 D. None of the above Futures price = 950 (1 + 0.05 - 0.03) = 969

Type: Difficult

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27. The current level of S & P 500 index is 1100. The prospective dividend yield is 3%, and the current interest rate is 7%. What is the value of a one-year futures contract on the index? (Assume all dividends are paid at the end of the year.) A. 1177 B. 1144 C. 1133 D. None of the above Futures price = 1100(1 + 0.07 - 0.03) = 1144

Type: Difficult

28. The spot price of wheat is $2.90/bushel. One year futures price is $3.00/bushel. If the riskfree rate is 5%, calculate the net convenience yield. A. -0.019 B. +0.019 C. +0.0345 D. None of the above Net convenience yield = (1 + 0.05) - (3.00/2.90) = +0.019

Type: Difficult

29. The spot price for delivery of home heating oil is $0.55 per gallon. The futures price for one year from now is $0.57. If the risk-free rate is 6% per year, what is the net convenience yield? A. 0.0411 B. 0.0364 C. 0.0236 D. 0.044 0.57 = 0.55(1 + 0.06-net convenience yield); net convenience yield = +0.0236

Type: Difficult

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30. A forward interest rate contract is called a A. Forward contract B. Forward Rate Agreement C. Futures Rate Agreement D. None of the above

Type: Easy

31. If the one-year spot interest rate is 6% and two-year spot interest rate is 7%, calculate the one-year forward interest rate one year from today (approximately): A. 6% B. 7% C. 8% D. None of the above Forward interest rate = ((1.07)(1.07)/1.06) - 1 = 8%

Type: Difficult

32. If the one-year spot interest rate is 8% and two-year spot interest rate is 9%, calculate the one-year forward interest rate one year from today (approximately): A. 10% B. 12% C. 14% D. None of the above Forward interest rate = ((1.09)(1.09)/1.08) - 1 = 10%

Type: Difficult

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33. Suppose you borrow $95.24 for one year at 5% and invest $95.24 for two years at 7%. For the time period beginning one year from today, you have: (approximately) A. Borrowed at 7% B. Invested at 7% C. Borrowed at 9% D. Invested at 9% +95.24(1.05) → - 100; 95.24(1.07)(1.07) → + 109.04; i.e. (Invest at 9%)

Type: Difficult

34. First National Bank has made a 5-year, $100 million fixed-rate loan at 10%. Annual interest payments are $10 million, and all principal will be repaid in year 5. The bank wants to swap the fixed interest payment into floating-rate payments. If the bank could borrow at a fixed rate of 8% for 5 years, what is the notional principal of the swap? A. $80 million B. $100 million C. $125 million D. $180 million 10/0.08 = 125

Type: Medium

35. Third National Bank has made 10-year, $25 million fixed-rate loan at 12%. Annual interest payments are $3 million, and all principal will be repaid in year 10. The bank wants to swap the fixed interest payments into floating-rate payments. If the bank could borrow at a fixed rate of 10% for 10 years, what is the notional principal of the swap? A. $40 million B. $20 million C. $25 million D. $30 million 3/0.1 = 30

Type: Medium

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36. Firm A is paying a fixed $700,000 in interest payments, while Firm B is paying LIBOR plus 50 basis points on $10,000,000 loans. The current LIBOR rate is 6.25%. Firm A and B have agreed to swap interest payments, how much will be paid to which Firm this year? A. A pays $750,000 to Firm B B. B pays 25,000 to Firm A C. B pays $50,000 to Firm A D. A pays $25,000 to Firm B Floating rate = 6.75%; Interest cost = $675,000; Fixed rate = 7.0%; Interest cost = $700,000; A pays $25,000 to B.

Type: Difficult

37. In a "total return swap" the asset might be a: I) common stock II) loan III) commodity IV) market index A. I and II only B. I, II and III only C. I, II, III and IV D. IV only

Type: Medium

38. Banks that have a portfolio of loans generally hedge against default of loans by: A. negotiating default swap on each individual loan B. buying credit option on each individual loan C. negotiate a portfolio default swap, which provides protection on the entire portfolio D. none of the above

Type: Medium

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39. A firm owns an asset A and it wants to hedge against changes in the value of A by making an offsetting sale of asset B. The firm minimizes risk if: A. Selling the same number of units of B as assets of A B. Selling hedge ratio (delta) number of units of B C. Selling the reciprocal of hedge ratio number of units of B D. None of the above

Type: Difficult

40. 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. Match 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: Medium

41. Four investors enter into long sugar contracts. Three are speculators and one is hedging. Which of the following is hedging? A. Farmer B. Cereal company C. Mutual fund D. None of the above

Type: Difficult

42. What investment would be a hedge for a corn farmer? A. Long corn put option B. Long corn call option C. Long corn futures D. None of the above

Type: Difficult

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True / False Questions

43. Disadvantages faced by insurance companies in bearing risk are: administrative costs, adverse selection and moral hazard. TRUE

Type: Easy

44. Derivative instruments are those whose value depends on the value of another asset. TRUE

Type: Medium

45. Options contracts are marked to market. FALSE

Type: Medium

46. "Mark to market" means that each day any profits or losses are calculated and your account is adjusted accordingly. TRUE

Type: Medium

47. For commodity futures: (Futures price)(1 + rf)^t = Spot price-net convenience yield. FALSE

Type: Medium

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48. Convenience yield is the extra value created by holding the actual commodity rather than a financial claim on it. TRUE

Type: Difficult

49. For financial futures, (Spot price)/(1 + rf - y)^t = Futures price. FALSE

Type: Medium

50. For commodity futures, net convenience yield = (convenience yield - storage costs). TRUE

Type: Medium

51. A company that wishes to lock in an interest rate on future borrowing can either enters into a FRA or it can borrow long-term funds and lend short-term. TRUE

Type: Difficult

52. If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 7.5% which is the average of the two rates. FALSE

Type: Difficult

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53. If a bank is asked to quote a rate on a one-year loan one year from today and the current interest rate on a one year loan is 7% and a two year loan is 8 %, it should quote 9%. TRUE One year loan one year from today: [(1.08)^2/(1.07)] - 1 = 0.09 = 9%

Type: Difficult

54. Hedge ratio or delta measures the sensitivity of the value of one asset relative to the value of another asset. TRUE

Type: Medium

55. Hedging requires an offsetting position. TRUE

Type: Medium

56. In a rising market, more derivatives investors will make money than lose money. FALSE

Type: Medium

Short Answer Questions

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57. What are the disadvantages faced by the insurance companies in bearing risk? There are three disadvantages faced by insurance companies in bearing risk. They are: • Administrative costs • Adverse selection • Moral hazard

Type: Medium

58. Briefly explain the term "derivatives." Derivative instruments or derivatives are instruments whose value depends on the value of another asset, which is the underlying asset. There are four types of derivatives: options, futures, forwards and swaps. These are mainly used for hedging but can easily be used for speculation.

Type: Medium

59. What are the four basic types of contracts or instruments used in financial risk management? The four basic types of contracts or financial instruments used in financial risk management are forwards, futures, options, and swaps.

Type: Easy

60. Are companies that trade in derivatives speculating? Whether a firm is hedging or speculating depends on the circumstances under which the firm is using these derivatives. There is a thin line separating hedging and speculating. It also depends on the type of risks a firm is exposed to and whether the activity in derivatives serves to reduce or increase risk.

Type: Medium

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Chapter 26 - Managing Risk

61. Briefly explain the term "marked to market." Futures contracts are marked to market. This means that each day any profit or losses on the contract is calculated. The investor's margin account is adjusted to reflect losses or profits at the end of each day. If the margin account falls below the maintenance margin then the investor is asked deposit sufficient funds to bring the margin account up to the maintenance margin. In case the investor has profits, he/she can withdraw that amount.

Type: Medium

62. Briefly explain the mechanics of homemade forward rate agreements. By borrowing short-term and lending long-term one can invest at the forward rate. On the other hand by borrowing long-term and lending short-term one can borrow at the forward rate.

Type: Medium

63. Briefly explain swaps. A swap is an exchange of securities or currencies between two firms. This generally involves exchanging obligations in different currencies, or one at a fixed rate and the other at a floating rate.

Type: Medium

64. Explain how a firm wishing to invest in floating rate investments can use a swap to manage its interest rate exposure? A firm desiring a floating rate investment but with a comparative advantage in the fixed rate market can invest in a fixed rate investment and enter into a swap arrangement with a counterparty to exchange the fixed rate of return for a floating rate return.

Type: Difficult

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Chapter 26 - Managing Risk

65. Briefly explain how options can be used for hedging. Since the option price is tied to the underlying asset price, options can be used for hedging. Since the option delta changes as the underlying asset price changes and time passes, optionbased hedges need to be adjusted frequently.

Type: Medium

66. What is the difference between hedging, speculation, and arbitrage? Hedging consists of utilizing financial instruments or contracts to reduce or eliminate the risk from fluctuating interest rates, exchange rates, and/or prices. The purpose of speculation is to profit from a change in future rate or price. Arbitrage is the process of buying in one market and simultaneously selling in another market in order to earn a risk-free profit.

Type: Difficult

67. Why are derivatives necessary for a thriving economy? Besides asset pricing, risk management is essential to a growing economy. Firms will not take risks unless they are able to mitigate those risks. The original insurance contracts allowed merchants to sail across the globe without fear that a casualty loss would be the end of their careers. Derivatives allow risk transfer and thus the ability of firms to manage and eliminate risk.

Type: Difficult

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