Question 1

A spot contract is for immediate delivery whereas a forward contract is for future delivery.

Accepted Answer

A spot contract is an agreement to buy or sell a currency or commodity at the current market price for immediate delivery, while a forward contract is an agreement to buy or sell a currency or commodity at a future date for a fixed price.

Question 2

Gains and losses on a futures contract must be recognized daily.

Accepted Answer

Gains and losses on a futures contract are marked-to-market daily, which means they are recognized on a daily basis. This ensures that all parties involved in the contract are aware of their current financial position and can take appropriate action if necessary.

Question 3

The lack of perfect correlation between spot and futures prices implies that most hedges will have some basis risk.

Accepted Answer

Basis risk occurs when there is not a perfect correlation between the spot and futures prices. This means that a hedge using futures contracts may not perfectly offset the potential losses in the underlying asset. Therefore, most hedges will have some basis risk.

Question 4

Swaps are usually the best hedging tool to use to hedge long-term risks of four or five years or more.

Accepted Answer

Swaps are ideal for hedging long-term risks because they allow parties to exchange future cash flows based on an agreed-upon fixed or floating rate, protecting against interest rate and currency fluctuations over several years.

Question 5

A purchaser of a bond call option gains if interest rates fall.

Accepted Answer

A bond call option gives the purchaser the right to buy a bond at a certain price, known as the strike price. If interest rates fall, the market value of the bond increases and the purchaser can sell the bond at a higher price than the strike price, thus making a profit. Therefore, the purchaser gains if interest rates fall.

Question 6

The writer of an American-style bond call option has the right,but not the obligation,to buy the bond at a preset price until the option expires.

Accepted Answer

The writer of an American-style bond call option has the obligation to sell the bond at a preset price if the option is exercised by the option holder. The option holder has the right, but not the obligation, to buy the bond at the preset price until the option expires.

Question 7

A macrohedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable.

Accepted Answer

The answer of A macrohedge is a hedge of a...

Question 8

A fixed-floating interest rate swap is called a plain vanilla swap.

Accepted Answer

This statement is true. A fixed-floating interest rate swap where one party pays a fixed rate and the other party pays a floating rate is a basic or simple type of interest rate swap, known as a plain vanilla swap.

Question 9

A U.S. corporation has a yen-denominated loan it must repay in six months. A long position in yen futures could help offset the corporation's foreign exchange risk.

Accepted Answer

A long position in yen futures would help offset the corporation's foreign exchange risk by allowing them to lock in a specific exchange rate for when the loan repayment is due, reducing the potential impact of fluctuations in the yen/USD exchange rate.

Question 10

The maximum gain (ignoring commissions and taxes)from buying an at-the-money bond put option is the bond price at time of option purchase less the put premium. The maximum loss is the put premium.

Accepted Answer

This is because if the bond price at expiration is lower than the strike price of the option, the option will be in-the-money and can be exercised to sell the bond at the higher strike price. The gain will then be the difference between the bond price and the strike price, minus the premium paid for the option. However, if the bond price at expiration is higher than the strike price, the option will expire worthless and the maximum loss will be the premium paid for the option.

Question 11

An FI with DA < kDL may choose to enter into a long-term swap in which it pays a fixed rate of interest and receives a variable rate in order to effectively reduce the duration gap.

Accepted Answer

The answer of An FI with DA < kDL may...

Question 12

The buyer of an American-style bond call option has the right,but not the obligation,to sell the bond at a set price until the option expires.

Accepted Answer

The buyer of an American-style bond call option has the right, but not the obligation, to buy the bond at a set price until the option expires, not sell the bond.

Question 13

A bank with a negative repricing gap could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest to effectively reduce its repricing gap.

Accepted Answer

A bank with a negative repricing gap would benefit from entering into an interest rate swap where it pays a fixed rate of interest and receives a variable rate of interest, which effectively reduces its repricing gap. This is because the bank's cash inflows (from receiving the variable rate of interest) will increase when interest rates rise, which offsets the higher cash outflows (due to paying the fixed rate of interest) that result from a negative repricing gap.

Question 14

Swaps and forwards are subject to contingent risk; exchange-traded futures and options are not.

Accepted Answer

Swaps and forwards are customized contracts that are not traded on an exchange, so they are subject to contingent risk, which is the risk that one party will not fulfill their obligations under the contract. Exchange-traded futures and options, on the other hand, are standardized contracts that are traded on an exchange, so they are not subject to contingent risk.

Question 15

Buying a cap is similar to buying a call option on bond prices.

Accepted Answer

Buying a cap is similar to buying a call option on interest rates, not bond prices. Caps are financial derivatives that protect against rising interest rates by setting a maximum (cap) rate, while call options on bonds give the holder the right to buy bonds at a specified price, which is more directly related to the bond's price rather than interest rates.

Question 16

As interest rates fall,bond prices and call option potential profits increase.

Accepted Answer

When interest rates fall, bond prices increase because the fixed interest rate of the bond becomes more attractive in a lower interest rate environment. As bond prices increase, call option potential profits also increase because the holder of the call option has the right to buy the bond at a lower price and sell it at a higher price, earning a profit.

Question 17

Forward contracts are not subject to default risk because the exchanges honor the contract in case the counterparty defaults; but future contracts are subject to default risk because they are non standardized contracts.

Accepted Answer

This statement is incorrect. Both forward and futures contracts are subject to default risk. While exchanges may provide mechanisms to mitigate this risk, such as margin requirements and clearinghouses, there is always potential for counterparty default. Additionally, not all futures contracts are non-standardized. Some exchanges offer standardized futures contracts alongside customizable ones.

Question 18

Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another.

Accepted Answer

Basis risk occurs when there is an imperfect correlation between the spot price and the price of the derivative used to hedge it, leading to unpredictable movements between the two.

Question 19

A bank has a positive repricing gap and wishes to protect its profits from an unfavorable interest rate move. Purchasing a cap will help limit this bank's interest rate risk.

Accepted Answer

The answer of A bank has a positive repricing gap...

Question 20

Writing a call option on a bond pays off if interest rates rise.

Accepted Answer

Writing a call option on a bond gives the holder the right to purchase the bond at a predetermined price if interest rates rise, which would result in the writer making a profit. Therefore, if interest rates do in fact rise, the call option would be exercised and the writer would receive the agreed upon price, resulting in a payoff.

Quiz 23: Managing Risk Off the Balance Sheet With Derivative Securities