Chapter 23 - Futures, Swaps, and Risk Management

Chapter 23 Futures, Swaps, and Risk Management

Multiple Choice Questions 1. Which one of the following stock index futures has a multiplier of $250 times the index value? A. Russell 2000 B. S&P 500 Index C. Nikkei D. DAX-30 E. NASDAQ 100 The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

2. Which one of the following stock index futures has a multiplier of $10 times the index value? A. Russell 2000 B. Dow Jones Industrial Average C. Nikkei D. DAX-30 E. NASDAQ 100 The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

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3. Which one of the following stock index futures has a multiplier of $500 times the index value? A. Russell 2000 B. FTSE 100 C. Nikkei D. DAX-30 E. NASDAQ 100 The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

4. Which one of the following stock index futures has a multiplier of $500 times the index value? A. Russell 2000 B. FTSE 100 C. S&P Mid-Cap D. DAX-30 E. A and C The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

5. Which one of the following stock index futures has a multiplier of $100 times the index value? A. Russell 2000 B. S&P 500 Index C. Nikkei D. DAX-30 E. NASDAQ 100 The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

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6. Which one of the following stock index futures has a multiplier of 10 euros times the index? A. CAC 40 B. DJ Euro Stoxx - 50 C. Nikkei D. DAX-30 E. A and B The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

7. Which one of the following stock index futures has a multiplier of 10 euros times the index? A. FTSE 100 B. DJ Euro Stoxx - 50 C. Nikkei D. DAX-30 E. A and B The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

8. Which one of the following stock index futures has a multiplier of 25 euros times the index? A. FTSE 100 B. DJ Euro Stoxx - 50 C. Nikkei D. DAX-30 E. A and B The multiplier is used to calculate contract settlements. See Table 23.1.

Difficulty: Easy

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9. You purchased one S&P 500 Index futures contract at a price of 950 and closed your position when the index futures was 947, you incurred: A. a loss of $1,500. B. a gain of $1,500. C. a loss of $750. D. a gain of $750. E. None of the above. (-$950 + $947) X 250 = - $750.

Difficulty: Moderate

10. You took a short position in two S&P 500 futures contracts at a price of 910 and closed the position when the index futures was 892, you incurred: A. a gain of $9,000. B. a loss of $9,000. C. a loss of $18,000. D. a gain of $18,000. E. None of the above. ($910 - $892) X 250 X 2 = $9,000

Difficulty: Easy

11. If a stock index futures contract is overpriced, you would exploit this situation by: A. selling both the stock index futures and the stocks in the index. B. selling the stock index futures and simultaneously buying the stocks in the index. C. buying both the stock index futures and the stocks in the index. D. buying the stock index futures and selling the stocks in the index. E. None of the above. If one perceives one asset to be overpriced relative to another asset, one sells the overpriced asset and buys the other one.

Difficulty: Moderate

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12. Foreign Exchange Futures markets are __________ and the Foreign Exchange Forward markets are __________. A. informal; formal B. formal; formal C. formal; informal D. informal; informal E. organized; unorganized The forward market in foreign exchange is a network of banks and brokers allowing customers to enter forward contracts to purchase or sell currency in the future at a currently agreed upon rate of exchange. The currency futures markets are formal markets established by the Chicago Mercantile Exchange where contracts are standardized as to size and daily marking to market is observed. A clearinghouse is also involved.

Difficulty: Easy

13. Suppose that the risk-free rates in the United States and in the United Kingdom are 4% and 6%, respectively. The spot exchange rate between the dollar and the pound is $1.60/BP. What should the futures price of the pound for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $1.60/BP B. $1.70/BP C. $1.66/BP D. $1.63/BP E. $1.57/BP $1.60(1.04/1.06) = $1.57/BP.

Difficulty: Moderate

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14. Suppose that the risk-free rates in the United States and in the United Kingdom are 5% and 4%, respectively. The spot exchange rate between the dollar and the pound is $1.80/BP. What should the futures price of the pound for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $1.62/BP B. $1.72/BP C. $1.82/BP D. $1.92/BP E. none of the above $1.80(1.05/1.04) = $1.82/BP.

Difficulty: Moderate

15. Suppose that the risk-free rates in the United States and in the Japan are 5.25% and 4.5%, respectively. The spot exchange rate between the dollar and the yen is $0.008828/yen. What should the futures price of the yen for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $0.009999/yen B. $0.009981/yen C. $0.008981/yen D. $0.008891/yen E. none of the above $0.008828 (1.0525/1.045) = $0.008891/yen.

Difficulty: Moderate

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16. Let RUS be the annual risk free rate in the United States, RUK be the risk free rate in the United Kingdom, F be the futures price of $/BP for a 1-year contract, and E the spot exchange rate of $/BP. Which one of the following is true? A. if RUS > RUK, then E > F B. if RUS < RUK, then E < F C. if RUS > RUK, then E < F D. if RUS < RUK, then F = E E. There is no consistent relationship that can be predicted. if RUS > RUK, then (1 + RUS)/(1 + RUK) > 1 and E < F.

Difficulty: Difficult

17. Let RUS be the annual risk free rate in the United States, RJ be the risk free rate in Japan, F be the futures price of $/yen for a 1-year contract, and E the spot exchange rate of $/yen. Which one of the following is true? A. if RUS > RJ, then E < F B. if RUS < RJ, then E < F C. if RUS > RJ, then E > F D. if RUS < RJ, then F = E E. There is no consistent relationship that can be predicted. if RUS > RJ, then (1 + RUS)/(1 + RJ) > 1 and E < F.

Difficulty: Difficult

Consider the following:

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18. What should be the proper futures price for a 1-year contract? A. 1.703 A$/$ B. 1.654 A$/$ C. 1.638 A$/$ D. 1.778 A$/$ E. 1.686 A$/$ 1.03/1.04(1.67 A$/$) = 1.654 A$/$.

Difficulty: Moderate

19. If the futures market price is 1.63 A$/$, how could you arbitrage? A. Borrow Australian Dollars in Australia, convert them to dollars, lend the proceeds in the United States and enter futures positions to purchase Australian Dollars at the current futures price. B. Borrow U.S. dollars in the United States, convert them to Australian Dollars, lend the proceeds in Australia and enter futures positions to sell Australian Dollars at the current futures price. C. Borrow U.S. dollars in the United States and invest them in the U.S. and enter futures positions to purchase Australian Dollars at the current futures price. D. Borrow Australian Dollars in Australia and invest them there, then convert back to U.S. dollars at the spot price. E. There is no arbitrage opportunity. E0(1 + rUS) - FO(1 + rA); use the U.S. $ values for the currency: 0.5988(1.04) - 0.6135(1.03) = -0.009153; when relationship is negative, action b will result in arbitrage profits.

Difficulty: Difficult

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20. If the market futures price is 1.69 A$/$, how could you arbitrage? A. Borrow Australian Dollars in Australia, convert them to dollars, lend the proceeds in the United States and enter futures positions to purchase Australian Dollars at the current futures price. B. Borrow U.S. dollars in the United States, convert them to Australian Dollars, lend the proceeds in Australia and enter futures positions to sell Australian Dollars at the current futures price. C. Borrow U.S. dollars in the United States and invest them in the U.S. and enter futures positions to purchase Australian Dollars at the current futures price. D. Borrow Australian Dollars in Australia and invest them there, then convert back to U.S. dollars at the spot price. E. There is no arbitrage opportunity. 0.5988(1.04) - 0.5917(1.03) = 0.013301; when this relationship is positive; action a will result in arbitrage profits.

Difficulty: Difficult

21. Assume the current market futures price is 1.66 A$/$. You borrow 167,000 A$ and convert the proceeds to U.S. dollars and invest them in the U.S. at the risk-free rate. You simultaneously enter a contract to purchase 170,340 A$ at the current futures prices (maturity of 1 year). What would be your profit (loss)? A. Profit of 630 A$ B. Loss of 2300 A$ C. Profit of 2300 A$ D. Loss of 630 A$ E. None of the above [A$ 167,000 / 1.67 x 1.04 x 1.66] - (A$ 167,000 x 1.03) = A$ 630.

Difficulty: Difficult

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22. Which of the following are examples of interest rate futures contracts? A. corporate bonds. B. Treasury bonds. C. Eurodollars. D. B and C E. A and B Interest rate futures are traded on Treasury bonds and Eurodollars. Examples that use these contracts to hedge are given in the textbook.

Difficulty: Easy

23. You hold a $50 million portfolio of par value bonds with a coupon rate of 10 percent paid annually and 15 years to maturity. How many T-bond futures contracts do you need to hedge the portfolio against an unanticipated change in the interest rate of 0.18%? Assume the market interest rate is 10 percent and that T-bond futures contracts call for delivery of an 8 percent coupon, paid annually 20-year _______ maturity T-bond. A. 398 contracts long B. 524 contracts short C. 1048 contracts short D. 398 contracts short E. none of the above 0.9864485 X $50 M = $49,322,429; $50,000,000 - $49,322,429 = $677,571 loss on bonds; $100.00 - $82.97 = $17.03 X 100 = $1703 gain on futures; $677,571/$1,703 = 398 contracts short.

Difficulty: Difficult

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24. A swap A. obligates two counterparties to exchange cash flows at one or more future dates. B. allow participants to restructure their balance sheets. C. allows a firm to convert outstanding fixed rate debt to floating rate debt. D. A and B. E. A, B, and C. A firm can enter into agreement to pay a floating rate and receive a fixed rate. Swaps involve an exchange of cash flows rather than securities.

Difficulty: Easy

25. Credit risk in the swap market A. is extensive. B. is limited to the difference between the values of the fixed rate and floating rate obligations. C. is equal to the total value of the payments that the floating rate payer was obligated to make. D. A and C. E. none of the above. Swaps obligate two counterparties to exchange cash flows at one or more future dates. Swaps allow firms to restructure balance sheets, and the firm is obligated only for the difference between the fixed and floating rates.

Difficulty: Easy

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26. Trading in stock index futures A. now exceeds buying and selling of shares in most markets. B. reduces transactions costs as compared to trading in stocks. C. increases leverage as compared to trading in stocks. D. generally results in faster execution than trading in stocks. E. all of the above. Trading in stock index futures now exceeds buying and selling of shares in most markets, reduces transactions costs as compared to trading in stocks, increases leverage as compared to trading in stocks, and generally results in faster execution than trading in stocks.

Difficulty: Moderate

27. Commodity futures pricing A. must be related to spot prices. B. includes cost of carry. C. converges to spot prices at maturity. D. all of the above are true. E. none of the above are true. Commodity futures are similar to other types of futures contracts but the cost of carrying must be considered. The cost of carrying includes interest costs, storage costs, and allowance for spoilage.

Difficulty: Easy

28. Arbitrage proofs in futures market pricing relationships A. rely on the CAPM. B. demonstrate how investors can exploit misalignments. C. incorporate transactions costs. D. all of the above. E. none of the above. No-arbitrage relationships are stronger than arguments such as the CAPM, but may be less precise if transactions or storage costs are not known.

Difficulty: Difficult

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29. One reason swaps are desirable is that A. they are free of credit risk. B. they have no transactions costs. C. they increase interest rate volatility. D. they increase interest rate risk. E. they offer participants easy ways to restructure their balance sheets. For example, a firm can change a floating-rate obligation into a fixed-rate obligation and vice versa.

Difficulty: Moderate

30. Which two indices had the lowest correlation between them during the 2001-2006 period? A. S&P and DJIA; the correlation was 0.957 B. S&P and NASDAQ; the correlation was 0.899 C. DJIA and Russell 2000 the correlation was 0.758 D. S&P and NYSE; the correlation was 0.973 E. NYSE and DJIA; the correlation was 0.931 The correlations are shown in Table 23.2.

Difficulty: Easy

31. Which two indices had the highest correlation between them during the 2001-2006 period? A. S&P and DJIA; the correlation was 0.957 B. S&P and Russell 2000 the correlation was 0.899 C. DJIA and Russell 2000 the correlation was 0.758 D. S&P and NYSE; the correlation was 0.973 E. NYSE and DJIA; the correlation was 0.931 The correlations are shown in Table 23.2.

Difficulty: Easy

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32. The value of a futures contract for storable commodities can be determined by the _______ and the model __________ consistent with parity relationships. A. CAPM, will be B. CAPM, will not be C. APT, will not be D. APT, will be E. A and D Both the CAPM and the APT can be used for this purpose and both will be consistent with parity relationships.

Difficulty: Moderate

33. In the equation Profits = a + b*($/ exchange rate), b is a measure of A. the firm's beta when measured in terms of the foreign currency. B. the ratio of the firm's beta in terms of dollars to the firm's beta in terms of pounds. C. the sensitivity of profits to the exchange rate. D. the sensitivity of the exchange rate to profits. E. the frequency with which the exchange rate changes. The slope of a line that plots profits vs. exchange rates gives the average amount by which profits will change for each unit change in the exchange rate.

Difficulty: Moderate

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34. You would like to take a position in the S&P500 stock index, but have decided to use market-index futures contracts and T-bills rather than actually purchasing the index. Your strategy will duplicate the payoff you would receive if you held the index and your goal is to time the market. If you want to minimize transactions costs and are bullish you should A. sell futures contracts and buy T-bills and shift back and forth between them as you expect the market to turn up or down. B. sell futures contracts and T-bills and shift back and forth between them as you expect the market to turn up or down. C. buy futures contracts and T-bills and shift back and forth between them as you expect the market to turn up or down. D. buy and hold futures contracts and shift in and out of T-bills as you expect the market to turn up or down. E. buy and hold T-bills and shift in and out of futures contracts as you expect the market to turn up or down. This strategy will duplicate the payoff of holding the index itself and will minimize transactions costs.

Difficulty: Difficult

You are given the following information about a portfolio you are to manage. For the longterm you are bullish, but you think the market may fall over the next month.

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35. If the anticipated market value materializes, what will be your expected loss on the portfolio? A. 14.29% B. 16.67% C. 15.43% D. 8.57% E. 6.42% The change would represent a drop of (1200 - 1400)/1400 = 14.3% in the index. Given the portfolio's beta, your portfolio would be expected to lose 0.6 * 14.3% = 8.57%

Difficulty: Moderate

36. What is the dollar value of your expected loss? A. $142,900 B. $16,670 C. $85,700 D. $30,000 E. $64,200 The dollar value equals the loss of 8.57% times the $1 million portfolio value = $85,700.

Difficulty: Easy

37. For a 200-point drop in the S&P500, by how much does the index change? A. $200,000 B. $50,000 C. $250,000 D. $500,000 E. $100,000 The change is 200 points times the $250 multiplier, which equals $50,000.

Difficulty: Easy

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38. How many contracts should you buy or sell to hedge your position? Allow fractions of contracts in your answer. A. sell 1.714 B. buy 1.714 C. sell 4.236 D. buy 4.236 E. sell 11.235 The number of contracts equals the hedge ratio = Change in portfolio value / Profit on one futures contract = $85,700/$50,000 = 1.714. You should sell the contract because as the market falls the value of the futures contract will rise and will offset the decline in the portfolio's value.

Difficulty: Moderate

39. You purchased sold S&P 500 Index futures contract at a price of 950 and closed your position when the index futures was 947, you incurred: A. A loss of $1,500. B. A gain of $1,500. C. A loss of $750. D. A gain of $750. E. None of the above. ($950 - $947) = $3 X 250 = $750.

Difficulty: Moderate

40. You took a short position in three S&P 500 futures contracts at a price of 900 and closed the position when the index futures was 885, you incurred: A. A gain of $11,250. B. A loss of $11,250. C. A loss of $8,000. D. A gain of $8,000. E. None of the above. ($900 - $885) = $15 X 250 X 3 = $11,250

Difficulty: Easy

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41. Suppose that the risk-free rates in the United States and in the Canada are 3% and 5%, respectively. The spot exchange rate between the dollar and the Canadian dollar (C$) is $0.80/C$. What should the futures price of the C$ for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $1.00/ C$ B. $1.70/ C$ C. $0.88/ C$ D. $0.78/ C$ E. $1.22/ C$ $0.80(1.03/1.05) = $0.78/ C$.

Difficulty: Moderate

42. Suppose that the risk-free rates in the United States and in the Canada are 5% and 3%, respectively. The spot exchange rate between the dollar and the Canadian dollar (C$) is $0.80/C$. What should the futures price of the C$ for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $1.00/ C$ B. $0.82/ C$ C. $0.88/ C$ D. $0.78/ C$ E. $1.22/ C$ $0.80(1.05/1.03) = $0.82/ C$.

Difficulty: Moderate

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43. Suppose that the risk-free rates in the United States and in the United Kingdom are 6% and 4%, respectively. The spot exchange rate between the dollar and the pound is $1.60/BP. What should the futures price of the pound for a one-year contract be to prevent arbitrage opportunities, ignoring transactions costs. A. $1.60/BP B. $1.70/BP C. $1.66/Bp D. $1.63/BP E. $1.57/BP $1.60(1.06/1.04) = $1.63/BP.

Difficulty: Moderate

You are given the following information about a portfolio you are to manage. For the longterm you are bullish, but you think the market may fall over the next month.

44. If the anticipated market value materializes, what will be your expected loss on the portfolio? A. 7.58% B. 6.52% C. 15.43% D. 8.57% E. 6.42% The change would represent a drop of (915 - 990)/990 = 7.58% in the index. Given the portfolio's beta, your portfolio would be expected to lose 0.86 * 7.58% = 6.52%

Difficulty: Moderate

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45. What is the dollar value of your expected loss? A. $142,900 B. $65,200 C. $85,700 D. $30,000 E. $64,200 The dollar value equals the loss of 6.52% times the $1 million portfolio value = $65,200.

Difficulty: Easy

46. For a 75-point drop in the S&P500, by how much does the index change? A. $200,000 B. $50,000 C. $250,000 D. $500,000 E. $18,750 The change is 75 points times the $250 multiplier, which equals $18,750.

Difficulty: Easy

47. How many contracts should you buy or sell to hedge your position? Allow fractions of contracts in your answer. A. sell 3.477 B. buy 3.477 C. sell 4.236 D. buy 4.236 E. sell 11.235 The number of contracts equals the hedge ratio = Change in portfolio value / Profit on one futures contract = $65,200/$18,750 = 3.477. You should sell the contract because as the market falls the value of the futures contract will rise and will offset the decline in the portfolio's value.

Difficulty: Moderate

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48. Covered interest arbitrage ____________. A. ensures that currency futures prices are set correctly B. ensures that commodity futures prices are set correctly C. ensures that interest rate futures prices are set correctly D. A and B E. none of the above Covered interest arbitrage ensures that currency futures prices are set correctly.

Difficulty: Easy

49. A hedge ratio can be computed as ____________. A. profit derived from one futures position for a given change in the exchange rate divided by the change in value of the unprotected position for the same exchange rate B. the change in value of the unprotected position for a given change in the exchange rate divided by the profit derived from one futures position for the same exchange rate C. profit derived from one futures position for a given change in the exchange rate plus the change in value of the unprotected position for the same exchange rate D. the change in value of the unprotected position for a given change in the exchange rate plus by the profit derived from one futures position for the same exchange rate E. none of the above A hedge ratio can be computed as the change in value of the unprotected position for a given change in the exchange rate divided by the profit derived from one futures position for the same exchange rate.

Difficulty: Moderate

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50. E-Minis typically have a value of ____________ percent of the standard contract and exist for ____________. A. 50; individual stocks and commodities B. 50; stock indexes and foreign currencies C. 40; stock indexes and commodities D. 20; individual stocks and commodities E. 20; stock indexes and foreign currencies E-Minis typically have a value of 20 percent of the standard contract and exist for stock indexes and foreign currencies.

Difficulty: Easy

51. The most common short term interest rate used in the swap market is A. the U.S. discount rate B. the U.S. prime rate C. The U.S. fed funds rate D. LIBOR E. none of the above None of the above are common short term interest rates used in the swap market.

Difficulty: Easy

52. If interest rate parity holds A. covered interest arbitrage opportunities will exist B. covered interest arbitrage opportunities will not exist C. arbitragers will be able to make risk-free profits D. A and C E. B and C If interest rate parity holds covered interest arbitrage opportunities will not exist

Difficulty: Moderate

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53. If interest rate parity does not hold A. covered interest arbitrage opportunities will exist B. covered interest arbitrage opportunities will not exist C. arbitragers will be able to make risk-free profits D. A and C E. B and C If interest rate parity holds covered interest arbitrage opportunities will not exist

Difficulty: Moderate

54. If covered interest arbitrage opportunities do not exist A. interest rate parity does not hold B. interest rate parity holds C. arbitragers will be able to make risk-free profits D. A and C E. B and C If interest rate parity holds covered interest arbitrage opportunities will not exist

Difficulty: Moderate

55. If covered interest arbitrage opportunities exist A. interest rate parity does not hold B. interest rate parity holds C. arbitragers will be able to make risk-free profits D. A and C E. B and C If interest rate parity holds covered interest arbitrage opportunities will not exist

Difficulty: Moderate

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Short Answer Questions 56. Why are commodity futures prices different from other futures prices? Explain the difference and give an example of a commodity and the factors involved. The price of a futures contract for a commodity that must be stored is given by F0 = P0 * (1 + rf + c), where P0 is the spot price of the commodity, rf is the risk-free rate that applies to the opportunity cost of holding the commodity, and c is the carrying cost. Commodity futures have an extra cost integrated into their price - carrying costs can be significant. Carrying costs can include interest costs, storage costs, insurance costs, and an allowance for spoilage of goods in storage. These costs should be considered on a net basis: costs minus the benefits of carrying the commodity, such as protection against running out of stock. An example is a contract on corn. If the producer doesn't sell the corn now, it will need to be stored for future delivery. There will be explicit costs like insurance and the marginal cost of silo usage, including the resources used to keep the corn at its proper moisture level. There may be some spoilage of the corn. An implicit cost is the opportunity cost of not investing the funds that would have been earned if the corn had been sold in the spot market. Feedback: This question tests whether the student recognizes the important difference in commodities contracts due to carrying costs.

Difficulty: Moderate

57. Suppose that the risk-free rate is 4% and the market risk premium is 6%. You are interested in a cocoa futures contract. The beta of cocoa is -0.291. - What is the required annual rate of return on the cocoa contract? - You plan to hold the contract for three months, then take delivery of the cocoa. At that time you expect the spot price of cocoa to be $900 per ton. What is the present value of this threemonth deferred claim? - What would the proper price be for this contract? The required rate of return is given by the CAPM. E(r) = 4% + (-.291) * 6% = 2.254%. The present value of the deferred claim is $900/(1.02254)0.25 = $895. The proper price for the contract would be determined by setting the present value of the commitment to pay F0 dollars in three months to $895. F0/(1.04)0.25 = $895. F0 = $903.82. Feedback: This question gives the student a chance to apply the CAPM to a storable commodity and to recognize the present value relationships that must hold.

Difficulty: Difficult

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58. Explain how a firm that has issued $1 million of long-term bonds with a fixed 6% interest rate can convert its fixed-rate debt into floating-rate debt. Give two numerical examples that show the possible outcomes, one favorable and one unfavorable. The firm can enter a swap arrangement, committing to pay .06 * $1 million = $60,000 in exchange for receiving payments equal to $1 million times the LIBOR rate. If the LIBOR rate is 5, the cash inflow would be $1 million * .05 = $50,000. The net cash flow would be $10,000 in this case, which is unfavorable. If the LIBOR rate is 8%, the firm will have a cash inflow of $1 million * .08 = $80,000. The net cash flow in this case is $20,000, which is favorable. Feedback: This is a basic question about the mechanics of a swap agreement.

Difficulty: Easy

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