Question 1

In a forward rate agreement (FRA), two parties agree today to a future exchange of cash flows based on two different interest rates.

Accepted Answer

In a forward rate agreement (FRA), two parties agree today to a future exchange of cash flows based on two different interest rates. One party agrees to pay a fixed rate while the other agrees to pay a floating rate calculated based on a reference rate such as LIBOR. The FRA allows parties to manage interest rate risk by locking in a future fixed or floating rate, depending on their needs.

Question 2

Equity swaps are traded in the OTC markets.

Accepted Answer

Equity swaps are traded in the Over-the-Counter (OTC) market, which means they are privately negotiated between two parties instead of being traded on an exchange.

Question 3

In an interest rate swap, the fixed rate payer profits if interest rates fall.

Accepted Answer

In an interest rate swap, the fixed rate payer benefits when interest rates rise, as they continue to pay the agreed fixed rate which becomes advantageous compared to the higher floating rates.

Question 4

The process by which invest on margin accounts are credited or debited to reflect daily trading gains or losses is referred to as the ____ process.

Accepted Answer

The process described in the question is known as marked-to-market. This process involves adjusting the value of the margin account based on the daily gains or losses from trading. This ensures that the margin account always reflects the current market value of the investments.

Question 5

A riskless stock index arbitrage profit is possible if the following condition holds: F_0,T = S₀(1 + r_f - d)^T, where spot price now is S₀, value now of a futures contract expiring at time T is (F_0,T), r_f is the risk free rate, and d is the dividend.

Accepted Answer

A riskless arbitrage profit is possible if the futures price deviates from the theoretical price, which is F_0,T = S₀(1 + r_f - d)^T. If the condition holds, the futures price is correctly priced, and no arbitrage profit is possible.

Question 6

If you were bearish on the near-term outlook for the stock market but did not want to sell your portfolio, you could hedge against the decline by selling stock index futures.

Accepted Answer

Selling stock index futures allows an investor to hedge against a decline in the stock market without selling their portfolio. If the stock market falls, the gain in the futures contract can offset the losses in the portfolio.

Question 7

The forward rate agreement is the most complicated of the OTC interest rate contracts.

Accepted Answer

Forward rate agreements (FRAs) involve the agreement to exchange a fixed rate of interest for a variable rate of interest on a specified future date, based on a notional amount. This can be more complex than other OTC interest rate contracts like interest rate swaps or caps/floors, which involve the exchange of fixed and variable rates over a longer period of time. Thus, FRAs are considered among the more complicated OTC interest rate contracts.

Question 8

While LIBOR is usually used with forward rate agreements, it is rarely used with other interest rate agreements.

Accepted Answer

This statement is false. LIBOR is commonly used with other interest rate agreements such as interest rate swaps, floating rate notes, and various other derivatives.

Question 9

The inclusion of dividends in the cost of carry model will increase the futures price.

Accepted Answer

Including dividends in the cost of carry model actually decreases the futures price, because dividends represent an income stream to the holder of the underlying asset, thus reducing the net cost of carrying or holding the asset.

Question 10

Like hedging, arbitrage results in increased returns with a disproportional increase in risk.

Accepted Answer

Arbitrage involves exploiting price differences of the same asset in different markets to make a profit without risk, whereas hedging is about reducing risk, not necessarily increasing returns disproportionately to risk.

Question 11

A plain vanilla swap agreement is used in similar situations as a forward rate agreement.

Accepted Answer

Both a plain vanilla swap agreement and a forward rate agreement are used to manage interest rate risks, with the former involving the exchange of fixed and floating rate payments and the latter involving a settlement based on a future reference interest rate. Thus, they can be used in similar situations.

Question 12

The major difference between valuing futures versus forward contracts stems from the fact that future contracts are

Accepted Answer

The major difference between valuing futures and forward contracts is that futures contracts are marked-to-market daily. This means the gains and losses from futures contracts are settled at the end of each trading day, unlike forward contracts, which are settled at the end of the contract term.

Question 13

Stock index futures are useful in providing a hedge against movements in an underlying financial asset.

Accepted Answer

Stock index futures allow investors to mitigate the risk of price movements in the underlying stock market index by taking opposite positions in the futures market. This helps to offset potential losses in a stock portfolio or other financial assets.

Question 14

The Eurodollar futures contract is a popular hedging vehicle because it is based on the three-month LIBOR.

Accepted Answer

Eurodollar futures contracts are indeed based on the three-month LIBOR (London Interbank Offered Rate), which is a benchmark interest rate used in financial markets. The futures contract allows market participants to hedge against changes in interest rates over the three-month period.

Question 15

If you have entered into a currency futures hedge for the Japanese yen in connection with buying Japanese equipment and if the yen goes from 110 yen/$1 to 100 yen/$1, you will lose in the spot market but have an offsetting gain in the futures market.

Accepted Answer

When the yen strengthens from 110 yen/$1 to 100 yen/$1, it means that you now need fewer yen to buy a dollar, indicating a loss if you have to convert dollars to yen in the spot market to buy the equipment. However, if you have a futures contract that locked in a rate closer to 110 yen/$1, you would gain on the futures contract because you have secured a rate that is more favorable than the current market rate of 100 yen/$1, offsetting the loss in the spot market.

Question 16

An investor who wants a long position in a ____ must first place the order with a broker, who then passes it on to the trading pit or electronic network. Details of the order are then passed on to the exchange clearinghouse.

Accepted Answer

Only futures contracts are traded on trading pits or electronic networks that operate in exchanges. Options and forward contracts, on the other hand, are traded in over-the-counter (OTC) markets where buyers and sellers negotiate the terms of the contract directly with each other.

Question 17

Equity swaps are equivalent to portfolios of forward contracts calling for the exchange of cash flows based on two different investment rates: (1) a variable debt rate and (2) the return to an equity index.

Accepted Answer

This is a correct statement about equity swaps. They involve exchanging cash flows based on a variable debt rate and the return to an equity index. This allows investors to gain exposure to equity market returns while also managing interest rate risk.

Question 18

As a contract approaches maturity, the spot price and forward price

Accepted Answer

As a contract approaches maturity, the spot price and the forward price tend to converge. This is because the forward price is determined by expectations of the spot price at maturity, and as the maturity date approaches, those expectations become more certain, causing the forward price to move closer to the spot price.

Question 19

On the settlement date for a forward rate agreement (FRA) contract, the difference between the two interest rates is multiplied by the FRA's par value and prorated by the length of the holding period.

Accepted Answer

The answer of On the settlement date for a forward...

Question 20

The Chicago Board of Trade (CBT) uses conversion factors to correct for differences in deliverable bonds.

Accepted Answer

The use of conversion factors is a common practice in the bond market, including those traded on the Chicago Board of Trade. These factors are meant to adjust for differences between the terms and conditions of different bonds that are eligible for delivery, ensuring a more standardized and efficient market.

Quiz 15: Forward, Futures, and Swap Contracts