Question 1

Options contracts are marked to market.

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Question 2

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

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Question 3

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.

Accepted Answer

The bank should actually quote a rate higher than 7.5% because there is a higher risk associated with providing a loan one year from now, as opposed to providing a loan immediately. This is known as the term premium or liquidity premium. Therefore, the correct answer is B, as it is incorrect to quote a rate that is simply the average of the two existing rates.

Question 4

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

Accepted Answer

Convenience yield is the additional value that comes from holding a physical commodity as opposed to a derivative or financial claim on that commodity. This value can be attributed to factors such as storage costs, transportation costs, and the ability to use the physical commodity for immediate consumption or production purposes.

Question 5

Briefly explain the term "derivatives."

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Question 6

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

Accepted Answer

Derivative instruments derive their value from an underlying asset such as a stock, bond, or commodity. Examples include options, futures, and swaps.

Question 7

Briefly explain the mechanics of homemade forward rate agreements.

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Question 8

Briefly explain the term "marked to market."

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Question 9

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

Accepted Answer

The correct relationship for commodity futures is: Futures price = Spot price * (1 + rf)^t - net convenience yield. The net convenience yield is subtracted, not included in the exponent.

Question 10

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%.
One year loan one year from today: [(1.08)^2/(1.07)] - 1 = 0.09 = 9%

Accepted Answer

The calculation provided is correct and results in a rate of 9%, so the bank should quote that rate for a one-year loan one year from today based on the current interest rates for one-year and two-year loans.

Question 11

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

Accepted Answer

The correct formula for pricing financial futures is Futures price = Spot price * (1 + rf - y)^t, where rf is the risk-free rate, y is the yield, and t is the time to maturity.

Question 12

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

Accepted Answer

This formula represents the definition of net convenience yield, which is the benefit derived from holding onto a physical commodity instead of investing in financial assets, after accounting for the costs associated with storage.

Question 13

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

Accepted Answer

Administrative costs of underwriting, policy issuance, claims settlement, and regulatory compliance are significant. Adverse selection occurs when people with a higher risk of loss are more likely to purchase insurance than those with a lower risk of loss. Moral hazard occurs when insurance policies encourage people to behave in ways that increase the likelihood of losses. These three factors increase the cost of bearing risk for insurance companies.

Question 14

Are companies that trade in derivatives speculating?

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Question 15

Hedging requires an offsetting position.

Accepted Answer

This is true. Hedging involves taking an offsetting position in order to reduce risk. For example, if a farmer wants to hedge against a decrease in crop prices, they might take a short position in the futures market, which would be offset by the long position they hold in the physical commodity.

Question 16

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

Accepted Answer

"Mark to market" accounting refers to the practice of calculating profits and losses each day, and adjusting the account balance accordingly, which is also known as "daily valuation".

Question 17

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

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Question 18

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

Accepted Answer

In a rising market, while many investors may profit, derivatives are zero-sum instruments, meaning for every winner, there is a loser.

Question 19

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

Accepted Answer

The statement is true. Hedge ratio or delta is a measure of the sensitivity of the value of one asset (such as an option or a security) relative to the value of another asset (such as the underlying security). It is commonly used in trading and risk management to create a hedge or a balanced portfolio.

Question 20

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.

Accepted Answer

By entering into a Forward Rate Agreement (FRA), a company can lock in an interest rate on future borrowing without actually borrowing any funds. Alternatively, the company can borrow long-term funds and lend short-term to try to lock in a lower borrowing rate, but this strategy comes with its own risks and costs.

Quiz 26: Managing Risk