Deck 9: Interest-Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

Question 1

According to your text there is no research evidence to support the notion that interest rates display seasonal patterns of highs and lows.

Answer 1

False

Question 2

Short- term interest rates tend to rise during the summer and fall months and to fall over the winter and spring months.

Answer 2

True

Question 3

If the Flow-of-Funds approach to forecasting interest rates projects that credit demand will be less than credit supply at current interest rates, this would be a forecast that interest rates will decrease in the future.

Answer 3

True

Question 4

An increase in the volume of security offerings shown on the forward calendar would, other things held equal, lead financial analysts to forecast lower interest rates as security dealers attempt to lighten their inventories of unsold securities.

Question 5

Indications that the U.S. Treasury will need to increase its level of borrowing in the open market should result in higher market interest rates.

Question 6

Interest-rate swaps necessarily reduce credit risk.

Question 7

Interest-rate swaps are not subject to interest-rate risk.

Question 8

The forecasting of interest rates has become a very precise science, reducing the uncertainty faced by financial managers.

Question 9

According to the money-supply income effect, if the money supply grows more slowly than planned spending, interest rates will rise.

Question 10

An index amortizing rate swap allows the parties to the swap to change interest rates over the life of the swap but the notional principal does not change.

Question 11

If an IAR swap uses LIBOR (the London InterBank Offer Rate) as an interest-rate index, then changes in LIBOR will affect the notional principal involved in the swap.

Question 12

Even interest rate protection products like swaps are subject to interest rate risk.

Question 13

The principal reason for the existence of a futures market is hedging.

Question 14

A rise in the market price of a security may be fully offset by a loss in the futures market.

Question 15

Hedging reduces risk, according to the textbook.

Question 16

The basic trading unit for Treasury notes is a $1 million face value on an 8-percent coupon rate.

Question 17

T-bills were declared eligible for trading in the U.S. financial futures market in January 1976.

Question 18

Most options are held to expiration.

Question 19

Under federal regulation in the U.S. commercial banks must limit their futures and options trading to hedging real risk-exposure situations.

Question 20

A perfect hedge contracts away all risk and creates a situation where any change in the market price is exactly offset by a profit or loss on the futures contract.

Question 21

Stock index futures make it possible to completely offset upward or downward movements in the Dow-Jones Industrial Average, but not in the Standard & Poor's 500 Stock Index.

Question 22

The seller of a stock index futures contract is betting on a bull (rising) stock market.

Question 23

Futures contracts are daily "marked to market"
which means each day the futures exchange clearinghouse sets the price at which they will be traded.

Question 24

The writer of a call option gains when the market value of the futures contract or security named in the option rises above the strike price.

Question 25

The International Monetary Market (IMM) was the first futures market to open in Europe.

Question 26

The LIBOR futures contract trades in $3 million units at the Chicago Mercantile Exchange.

Question 27

Barings Brothers collapsed in 1995 due to massive losses from trading derivatives instruments.

Question 28

As the global financial system becomes "smaller"
through technological advances, alliances and mergers among the world's leading securities exchanges are likely to continue.

Question 29

Derivatives continue to gain popularity, with the outstanding value in 2006 at more than $280 trillion.

Question 30

Hedging is a low-cost method of transferring the risk of unanticipated changes in asset prices or interest rates from one investor or institution to another.

Question 31

As the delivery date specified in the futures contract draws nearer, the gap or basis between the futures and spot prices for the same asset narrows.

Question 32

The Europeans, through firms such as EUREX, are moving into derivatives markets that traditionally have been the province of the US Chicago Board of Trade, (CBOT) and the Chicago Mercantile Exchange CME).

Question 33

During a period of economic expansion, according to your text,

A) Debt security prices typically rise
B) Interest rates tend to fall
C) Long-term interest rates increase faster than short-term interest rates
D) Interest rates typically rise
E) None of the above

Question 34

If projected money supply growth exceeds projected GNP growth, interest rates are likely to:

A) Rise
B) Fall
C) Remain stable unless inflation (the Fisher effect) intervenes
D) Remain unchanged unless the business cycle turns downward with slower GNP growth
E) None of the above

Question 35

A swap can be effectively hedged against interest-rate risk by:

A) Selling out to another party
B) Entering into another swap agreement that is the mirror image of the first swap
C) Setting interest-sensitive assets equal to interest-sensitive liabilities
D) Setting asset duration equal to liability duration
E) None of the above

Question 36

Swaps are used to protect against ____ risk, but they do not automatically protect the two parties from ____ risk.

A) Interest-rate, default
B) Default, liquidity
C) Liquidity, interest rate
D) Call, default
E) Forecasting, principal

Question 37

If market interest rates rise, the value of a financial futures contract will:

A) Rise
B) Fall
C) Remain constant because the value is determined by prices in the future
D) The change in value depends on the maturity of the futures contract
E) None of the above

Question 38

The ____ suggests that an increase in the growth rate in the money supply results in lower interest rates in
The short-run.

A) Fisher effect
B) Harrod-Keynes effect
C) GAP effect
D) Money-supply expectations effect
E) Money-supply liquidity effect

Question 39

In an IAR swap what amount is adjusted as market interest rates move?

A) The long-term fixed interest rate
B) The short-term reference interest rate
C) The notional principal
D) Both a and c are adjusted
E) None of the above

Question 40

In the late 1990's, Japanese government bond yields dropped to the lowest level in modern history.
Reasons for this include:

A) Japan was experiencing a prolonged national recession
B) Savers eschew stocks, instead bidding up bond prices
C) Business owners had little demand for credit
D) All of the above
E) Choices A and C only

Question 41

The Chicago Board of Trade opened active trading in futures contracts in October 1975, but the only type of contracts to be traded at that time were:

A) U.S. Treasury bonds
B) U.S. Treasury notes
C) U.S. Treasury bills
D) GNMA mortgage-backed certificates
E) 90-day commercial paper
F) Bank certificates of deposit

Question 42

The basic trading unit for Treasury bonds is:

A) $1 million
B) $100,000
C) $250,000
D) $500,000
E) None of the above

Question 43

In order to buy an option, one must pay the writer a:

A) Strike price
B) Market price
C) Margin
D) Premium
E) Basis

Question 44

Which of the following is a true statement?

A) A long hedge involves the purchase of futures contracts before the investor must buy the actual securities
B) The purpose of a long hedge is to guarantee a desired yield
C) The immediate sale of financial futures contracts is characteristic of a short hedge
D) A combined transaction between the spot and futures markets using different types of securities in each is a cross hedge
E) All of the above

Question 45

The principal amount or unit for the Federal funds futures contract traded on the Chicago Board of Trade is:

A) $5 million
B) $1 million
C) $100,000
D) $10 million
E) None of the above

Question 46

The term of the Federal funds futures contract traded at the Chicago Board of Trade is:

A) 30 days
B) 60 days
C) 90 days
D) 180 days
E) 1 year

Question 47

The old line British investment bank and security dealer that collapsed in 1995 due to massive losses in trading derivatives was:

A) National Westminster Bank
B) Barings Brothers
C) Royal Dominion Securities
D) British Royal Ltd
E) None of the above

Question 48

Beginning after December 1998, a new FASB rule relating to reporting about derivatives came into existence. The rule's primary requirement compels firms to:

A) Lay off any derivatives exposure prior to 12/31/2004
B) Clearly state the book value of derivative contracts and their possible effect on the firm's revenues
C) Report the market value of their derivative contracts and adjust earnings to reflect any changes in market value
D) All of the above
E) Choices B and C only

Question 49

Misuse of derivative contracts caused the failure of Barings bank and the near-collapse of Long-Term Capital Management. As a result of these (and other) examples, the following things have happened:

A) All new derivatives traders will be licensed by the World Bank
B) The Federal Reserve is regulating derivatives sales over $1 million
C) Creditors and counterparties have intensified their oversight and risk analysis of derivatives activities within their financial institutions
D) All of the above none of the above

Question 50

Derivatives continue to gain popularity, with the outstanding value in 2006 at more than

A) $150 billion
B) $200 trillion
C) $280 trillion
D) $350 trillion
E) None of the above

Question 51

When cash and futures prices or interest rates move parallel

A) The basis risk is one
B) The volatility ratio is zero
C) The basis risk is zero
D) The volatility ratio is .5
E) None of the above

Question 52

Suppose you could forecast interest rates correctly on a consistent basis. What advantages would this give to you?

Question 53

Explain the meaning of the following terms:

Question 54

Please explain the meaning of the term consensus forecast.

Question 55

What is interest-rate hedging? What is its goal?

Question 56

What are interest-rate swaps? Why were these instruments developed?

Question 57

What risks are associated with swap contracts? Can any of these risks be reduced?

Question 58

When is a partner to a swap in a long position? A short position? To what kinds of risk is each exposed to?

Question 59

What is the basic purpose of futures and options trading in securities? Where is most futures and options trading carried out?

Question 60

How do the spot (cash) markets differ from futures (forward) markets?

Question 61

What is basis? Explain how the basis for a futures contract relates to trading risk.

Question 62

For what specific kinds of securities is there now an active futures market? Who issues these securities?

Question 63

Define and explain the use of the following: long hedge, short hedge and cross hedge.

Question 64

Explain the uses of the following instruments: Call options, Put options.

Question 65

What risks and costs are inherent in financial futures and options trading?

Question 66

What position in the swap market does each of the following parties occupy?

Question 67

A large money center bank plans to offer money market CDs in substantial volume (at least $100 million) in six months due to a projected upsurge in credit deals from some of its most valued corporate customers. Unfortunately, the bank's economist has just predicted that money market interest rates should rise over the next year (with perhaps a full 1.5 percentage point increase within the next six months). Explain why the bank's management would be concerned about this development. Suppose management expects its corporate loan customers to resist any loan terms that would automatically result in loan rates being immediately adjusted upward to reflect any rate increases in the money market. What futures market transaction would you recommend? What is the best options contract alternative for the bank?

Question 68

An investment banking firm discovers that 90 days from today, it is due to receive a cash payment from one of its corporate clients of $972,500. The firm's portfolio manager is instructed to plan to invest this new cash for a horizon of three months, after which it will need to be liquidated. Interest rates
are attractive today at 10 percent, but a steep decline is forecast due to a developing recession. The portfolio manager decides to try to guarantee a 9 percent rate of return today on this planned three-month investment of cash.
a. Describe what the manager should do today in the financial futures market. Then, indicate how he will close out the futures position eventually.
b. What are the appropriate (buy-sell) steps for the manager if options on financial futures are to be used? T

Question 69

During the month just concluded, the prices of U.S. Treasury bonds fluctuated between a price of $95 (based on a $100 par value) and a price of $93. Treasury bond futures over the same period fluctuated between $92 and $88 (based on a $100 par value). How did the basis for T-bond futures contracts change over this period? What was the volatility ratio for T-bond futures for the month just ended? Using the volatility ratio you have just calculated and assuming you wish to hedge for the next 30 days $25 million in Treasury bonds that you currently hold with $100,000 denomination T-bond futures contracts maturing in 90 days, how many T-bond futures contracts will you need to buy to fully cover the $25 million in securities at risk?