Chapter 23—Risk Management
MULTIPLE CHOICE
1. Why might a financial manager prefer using option contracts instead of futures or forward contracts to
hedge?
a.
Futures and forwards require a premium be paid up front, while options do not.
b.
Options provide protection against adverse price movements but allow the user to profit if
the price of the underlying asset moves favorably.
c.
Options create an obligation to perform, while futures and forwards do not.
d.
Futures and forwards all have greater default risk than options.
2. Suppose rising gas prices cut into consumer spending, and Wal-mart, Target, and other retailers
experience a slow-down in sales. This slow-down is an example of
a.
an economic exposure
b.
a transaction exposure
c.
a translation exposure
d.
an alternatives exposure
3. Which of the following is NOT a motivation for hedging?
a.
Reducing the costs of financial distress
b.
Enhancing the ability to evaluate managers
c.
Offsetting the costs of insurance
d.
Reducing the firm’s expected tax liability
4. Which of the following is a (are) key difference(s) a manager should note in choosing between forward
and futures contracts?
a.
Exchange trading makes forward contracts more liquid.
b.
Futures contracts carry standardized terms, while forward contracts can be tailored to meet
specific needs.
c.
Futures contracts have greater default risk than forward contracts.
d.
Forward contracts require initial margin deposits and daily marking to market, while
futures do not.
5. A standard “fixed for floating” interest rate swap contract is effectively
a.
a series of call options on the interest rate.
b.
a series of put options on the interest rate.
c.
a series of forward rate agreements.
d.
none of the above.
6. The spot rate on the British pound is 0.5491 per U.S. dollar, while the risk-free borrowing rates are 4%
in Britain and 3% in the United States. What is the “fair” forward exchange rate?
a.
0.5438 pounds per dollar
b.
0.7321 pounds per dollar
c.
0.4118 pounds per dollar
d.
0.5544 pounds per dollar
7. The Exim Company has entered into a 3 month, $250 million notional principal forward rate
agreement (FRA) with What-a-Bank. The terms are such that Exim will pay What-a-Bank if LIBOR is
above 2%, but What-a-Bank will pay Exim if LIBOR is below 2%. Based on the standard FRA
formula, who will pay and how much, if LIBOR is 1.625% in three months?
a.
Exim Company pays $1,244,942
b.
Exim Company pays $233,427
c.
What-a-Bank pays $1,244,924
d.
What-a-Bank pays $233,427
8. You are a financial manager with ICN, Co. and you have used a forward contract to hedge a yen
100,000,000 payment the company expects in 90 days. Your contract calls for you to deliver yen at
111.25 yen per U.S. dollar. Suppose the spot rate at that time is 109.75 yen per U.S. dollar. Did you
gain or lose on the hedge? How much?
a.
Gain, $12,285.33
b.
Loss, $12,285.33
c.
Gain, $66,666.67
d.
Loss, $66,666.67
9. Outsource, Inc. expects a payment from a French customer in thirty days. To hedge its currency
exposure, Outsource should
a.
Sell euros forward thirty days.
b.
Buy euros forward thirty days.
c.
Sell dollars forward thirty days.
d.
Do nothing as there is no foreign exchange rate exposure for a thirty day time horizon.
10. You are a financial manager with JCN, Co. and you have used a forward contract to hedge a yen
100,000,000 payment the company expects to receive in 90 days. Your contract calls for you to deliver
yen at 109.75 yen per U.S. dollar. Suppose the spot rate at that time is 111.25 yen per U.S. dollar. Did
you gain or lose on the hedge? How much?
a.
Gain, $66,666.67
b.
Loss, $66,666.67
c.
Gain, $12,285.33
d.
Loss, $12,285.33
11. The Exim Company has entered into a 3 month, $250 notional principal forward rate agreement (FRA)
with What-a-Bank. The terms are such that Exim will pay What-a-Bank if LIBOR is above 2%, but
What-a-Bank will pay Exim if LIBOR is below 2%. Based on the standard FRA formula, who will pay
and how much, if LIBOR is 2.375% in three months?
a.
Exim Co. pays, $1,475,614
b.
Exim Co. pays, $232,992
c.
What-a-Bank pays, $1,475,614
d.
What-a-Bank pays, $232,992
12. If the spot exchange rate is 110 yen per U.S. dollar, the “fair” forward exchange rate is 115 yen per
U.S. dollar, and the risk-free borrowing rate in the United States is 2.5%, what must the risk-free
borrowing rate be in Japan?
a.
7.2%
b.
5.6%
c.
3.7%
d.
0%
NARRBEGIN: MakeStuff Company
MakeStuff Company
The MakeStuff Company’s earnings stream is highly dependent on the cost of a key commodity input.
Management believes taxable earnings will be $100,000 if the input price is low, taxable earnings will
be $50,000 if the input price is at a moderate level, but earnings will be zero if the input price is high.
Management sees these outcomes as being equally likely. The company pays a 15% tax rate on the
first $50,000 of taxable earnings, and a 25% rate on all earnings above $50,000.
NARREND
13. What is MakeStuff’s tax liability if the input price is at the moderate level?
a.
$7500
b.
$10,000
c.
$12,500
d.
none of the above
14. What is MakeStuff’s expected after tax earnings if it remains unhedged?
a.
$50,000
b.
$42,500
c.
$80,000
d.
$40,833
15. What is MakeStuff’s after-tax earnings if it can lock in the moderate price level for sure?
a.
$50,000
b.
$42,500
c.
$80,000
d.
$40,333
NARRBEGIN: CBOE
CBOE
Use the following information on CBOE 13-week T-bill rate options to answer the following
question(s).
Strike Level
OCT Call
OCT Put
30
1.50
0.75
35
1.20
1.10
40
1.00
1.40
NARREND
16. Refer to CBOE. Suppose you want to cap your interest rate before a planned October borrowing. What
is the cost of using the OCT 35 option to hedge?
a.
$110 per contract
b.
$1.10 per contract
c.
$120 per contract
d.
$1.20 per contract
17. Refer to CBOE. If you used the OCT 35 option to hedge rising rates, and the yield to maturity (YTM)
on 13-week bills is 3.75 percent at the option’s expiration, what is the outcome of your hedge?
a.
profit of $250 per contract
b.
profit of $130 per contract
c.
loss of $120 per contract
d.
no gain or loss, the option expires worthless
18. Refer to CBOE. What is the cost of the least expensive floor to protect from falling interest rates?
a.
$75 per contract
b.
$0.75 per contract
c.
$100 per contract
d.
$1.00 per contract
19. Refer to CBOE. Suppose you want to construct a collar to reduce the cost of the cap by selling a floor.
What is the net cost of the least expensive such collar? (Be sure the strike prices on the call and the put
are NOT the same!)
a.
$0.10 per contract outflow
b.
$10 per contract outflow
c.
$0.10 per contract inflow
d.
$10 per contract inflow
20. Suppose the spot exchange rate is 0.5491 pounds per U.S. dollar, while the risk-free borrowing rate is
4% in Britain. If the “fair” exchange rate is 0.5544 pounds per U.S. dollar, what is the risk-free
borrowing rate in the United States?
a.
5%
b.
4%
c.
3%
d.
2%
21. Suppose the spot exchange rate is 0.5491 pounds per U.S. dollar, while the risk-free borrowing rates
are 4% in Britain and 3% in the United States. If the current forward exchange rate is also 0.5491
pounds per dollar, what opportunity exists?
a.
Arbitrage by borrowing in Britain today, and selling pounds forward.
b.
Arbitrage by borrowing in Britain today, and selling dollars forward.
c.
Arbitrage by borrowing in the United States today, and selling pounds forward.
d.
Arbitrage by borrowing in the United States today and selling dollars forward.
22. Snooty Wine Importers has an order of exclusive Chateau de Snoot wines arriving from France in
October, and the order will be paid in euros. Which of the following will hedge the importer’s
currency exposure?
a.
buy euros forward
b.
sell euros forward
c.
sell dollars forward
d.
sell wine futures
23. Suppose Snooty Wine Importers has an order of Chateau de Snoot wines arriving from France in
October, and the order will be paid in euros. If Snooty enters a contract today with a forward rate of
0.9 euros per U.S. dollar for October delivery, and the spot rate in October turns out to be euro 0.85
per U.S. dollar, what is the effect of the forward contract on Snooty?
a.
Snooty Importers made $37,500
b.
Snooty Importers lost $37,500
c.
Snooty Importers made $637,55
d.
There is no effect.
24. Suppose the spot price of oil is $49.50 per barrel, while the October futures price is $51.00 per barrel.
For this contract, the basis is
a.
$51.00
b.
$49.50
c.
$1.50
d.
$100.50
25. Today, the price of an October oil futures contract closed at $49.50 per barrel. Yesterday, the contract
closed at $50.25. When margin accounts are marked to market,
a.
long positions will have $0.75 per barrel added.
b.
long positions will have $0.75 per barrel deducted.
c.
short positions will have $0.75 per barrel deducted.
d.
no changes are made until the October expiration.
26. The process of identifying firm-specific risk exposures and managing those exposures is called
a.
capital management
b.
risk management
c.
financial management
d.
none of the above
27. The overall impact of foreign exchange rate fluctuations on a firm’s value is called
a.
interest rate risk
b.
transaction exposure
c.
economic exposures
d.
none of the above
28. The average price at which a futures contract sell at the end of the trading day is called the
a.
opening price
b.
closing price
c.
settlement price
d.
lifetime price
29. The minimum dollar amount required by an investor when taking a position in a futures contract is
called the
a.
initial margin
b.
maintenance margin
c.
margin account
d.
none of the above
30. A call option on interest rates is called an
a.
interest rate collar
b.
interest rate floor
c.
interest rate cap
d.
interest rate swap
31. You plan to buy a 2 year zero coupon bond one year from today. If the risk free rate is 5.6% and a
three year zero-coupon bond currently sells for $843.25, what should be the forward price?
a.
$890.47
b.
$943.25
c.
$925.89
d.
$1045.72
32. You plan to buy a 2 year zero coupon bond one year from today. If the risk free rate is 5.6% and the
forward price for the bond is $843.25, what should be the current price of a three year zero-coupon
bond?
a.
$943.25
b.
$893.23
c.
$996.07
d.
$798.53
33. If the current spot exchange rate on the Euro is $1.2812/€ and the one year risk free rate for borrowing
in dollars is 3% and 4% for borrowing in Euros, what should be the one year $/€ forward exchange
rate?
a.
1.2812
b.
1.2689
c.
1.2936
d.
1.2469
34. If the current spot exchange rate on the Euro is €0.7805/$ and the one year risk free rate for borrowing
in dollars is 3% and 4% for borrowing in Euros, what should be the one year $/€ forward exchange
rate?
a.
1.2689
b.
0.7881
c.
1.2936
d.
0.7730
35. If the current spot exchange rate on the Euro is $1.2812/€ and the two year risk free rate for borrowing
in dollars is 3% and 4% for borrowing in Euros, what should be the two year $/€ forward exchange
rate?
a.
1.2689
b.
1.2812
c.
1.2567
d.
1.2469
NARRBEGIN: Exhibit 17-1
Exhibit 23-1
S&P 500 Index; $250 ´ index May 2004
Open
Low
Settle
Lifetime High
Lifetime
Low
Open
Interest
June
1029.5
1028.6
1041.35
1044.20
829.05
183,158
Sept
1039.3
1039.0
1049.9
1052.8
907.50
8,621
Dec
1051.4
1051.0
1059.35
1062.20
953.00
3,338
NARREND
36. Refer to Exhibit 23-1. If you are interested in purchasing a September S&P 500 index futures contract,
what is the value of that contract?
a.
$524,950
b.
$210,569
c.
$329,574
d.
$262,475
37. Refer to Exhibit 23-1. What was the lowest value of the December contract on the day quoted?
a.
$265,500
b.
$262,750
c.
$264,837
d.
$271,450
38. Refer to Exhibit 23-1. What is the highest value at which the June contract has ever been quoted?
a.
$257,150
b.
$207,262
c.
$261,050
d.
$278,695
39. Refer to Exhibit 23-1. For the purpose of marking to market what is the current value of the December
contract?
a.
$262,850.00
b.
$264,837.50
c.
$265,550.00
d.
$238,250.00
40. Refer to Exhibit 23-1. How many June contracts were outstanding at the end of the trading day?
a.
3,338
b.
8,621
c.
183,158
d.
125,845
41. Refer to Exhibit 23-1. If you hold a long position of 20 June S&P 500 index futures contracts, how
much compensation do you receive for the increase in the futures price at the end of the trading day?
a.
$58,500
b.
$11.70
c.
$2,925
d.
$234
42. You buy 20 corn futures contracts when the futures price is $3.67 per bushel (each contract is for
5,000 bushels). If you eventually settle the contract at $3.78, what is your profit?
a.
$11,000
b.
$13,000
c.
$9,500
d.
$15,000
43. You sell 20 corn futures contracts when the futures price is $3.67 per bushel (each contract is for 5,000
bushels). If you eventually settle the contract at $3.78, what is your payoff?
a.
$11,000
b.
-$11,000
c.
$13,000
d.
-$13,000
Exhibit 23-2
Coffee; 37,500 lbs per contract, $ per lb. May 2004
Open
Low
Settle
Lifetime High
Lifetime Low
Open Interest
June
1.05
1.05
1.12
1.59
1.03
17,832
Sept
1.08
1.08
1.13
1.51
1.07
6,379
Dec
1.11
1.11
1.16
1.43
1.10
1,397
NARREND
44. Refer to Exhibit 23-2. If you are interested in purchasing a December futures contract, what is the
price of a 37,500 lbs contract for December delivery?
a.
$43,500
b.
$37,500
c.
$32,500
d.
$47,500
45. Refer to Exhibit 23-2. What was the lowest contract price for coffee futures for June delivery on this
trading day?
a.
$39,375
b.
$37,500
c.
$38,625
d.
$42,000
46. Refer to Exhibit 23-2. What was the highest contract price that the September coffee future has traded
for over its lifetime?
a.
$40,125
b.
$56,625
c.
$40,500
d.
$42,375
47. Refer to Exhibit 23-2. For purposes of marking to market, what is the current price of coffee futures
for December?
a.
$41,625
b.
$53,625
c.
$41,250
d.
$43,500
48. Refer to Exhibit 23-2. Suppose that yesterday you purchased one September coffee futures contract at
the settle price. At the end of today’s trading day what is the change in the value of your contract?
a.
$3,000
b.
-$3,000
c.
$3,750
d.
-$3,750
49. Refer to Exhibit 23-2. Suppose that yesterday you sold one September coffee futures contract at the
settle price. At the end of today’s trading day what is the change in the value of your contract?
a.
$3,000
b.
-$3,000
c.
$3,750
d.
-$3,750
50. Refer to Exhibit 23-2. How many December coffee futures contracts were outstanding at the end of the
trading day?
a.
17,832
b.
6,379
c.
1,397
d.
7,776
51. Which of the following has led to an increase in demand for strategies to hedge corporate risk?
a.
fluctuations in interest rates
b.
fluctuations in exchange rates
c.
fluctuations in the price of raw materials
d.
all of the above
52. In historical terms, although not necessarily the case now, risk management has focused on
firm-specific events such as
a.
currency risk.
b.
interest rate risk.
c.
worker’s compensation claims.
d.
none of the above.
53. What is the single most common concern among managers engaged in risk management?
a.
interest rate risk
b.
currency exchange risk
c.
raw materials price risk
d.
none of the above
54. If your firm produces a product that is used primarily by gold producers, then your firm might be
subject to a risk related to the price of gold. If that risk is indirectly related to the price of gold, then
this is an example of
a.
transaction exposure.
b.
translation exposure.
c.
economic exposure.
d.
none of the above.
55. For most firms the principle reason for hedging is
a.
to reduced the likelihood of financial distress.
b.
to comply with SEC regulations concerning firm risk tolerances.
c.
to satisfy the owners of the firm’s shares.
d.
to satisfy the owners of the firm’s debt.
56. You are the manager of a company that has an equal chance of earning either $20,000 or $40,000
before taxes. Your firm is subject to a 20% tax rate on the first $30,000 and 35% on all income earned
beyond that point. If you are offered a costless hedge to achieve guaranteed before tax earnings of
$30,000, what is the expected benefit to hedging?
a.
$24,000
b.
$23,250
c.
$750
d.
none of the above
57. If the managers of a firm have a greater aversion to risk, then
a.
they are less likely to hedge.
b.
they are more likely to hedge.
c.
they are more likely to use derivatives to speculate.
d.
none of the above.
58. You need to purchase apples 1-month from now and would like to hedge against price movements in
apples. The spot price for apples is $5 a bushel and the risk-free rate is 10%. What is the 1-month
forward price for a bushel of apples?
a.
$4.96
b.
$5.00
c.
$5.04
d.
$5.50
59. You need to purchase coal 4-months from now and would like to hedge against price movement. The
spot price for coal is $50 a railroad car and the risk-free rate is 8%. What is the 4-month forward price
for a railroad car of coal?
a.
$48.73
b.
$50.00
c.
$51.30
d.
$54.00
60. You find that the 6-month forward price for scrap steel is $15 a ton. If the 6-month risk-free rate is
10%, then what should be the spot price for scrap steel per ton?
a.
$14.30
b.
$15.00
c.
15.73
d.
$16.50
61. You notice that the spot price of beef loin is $30 per pound and the 9-month forward rate is $32.66 per
pound. What is the annualized 9-month risk free rate of interest?
a.
6.58%
b.
8.87%
c.
10.00%
d.
12.00%
62. You notice that the spot price of beef loin is $30 per pound and the 9-month forward rate is $33.00 per
pound. The annualized 9-month risk free rate of interest is 12%. What amount of arbitrage profits are
available to you?
a.
$.60
b.
$.34
c.
-$.34
d.
-$.60
63. The spot rate exchange rate for Andromedan Pixels (ANP) is 3.00ANP/$. If the risk-free rate of return
in Andromeda is 20% per annum while that in the U.S. is 3%, then what should be the 1-year forward
rate for ANP/$?
a.
$2.57
b.
$3.00
c.
$3.50
d.
$3.60
64. The spot rate exchange rate for Andromedan Pixels (ANP) is 3.00ANP/$. If the risk-free rate of return
in Andromeda is 20% per annum while that in the U.S. is 3%, then what amount of U.S. dollars should
you be able to convert 3,000,000 ANP into 1-year from now if you choose to begin hedging today?
a.
$1,165,049
b.
$1,000,000
c.
$858,333
d.
$833,333
65. You have entered into a FRA with a notional amount of $100,000,000 which says that if 1-year
LIBOR is greater than 5% then the bank will pay you and vice versa if the rate is less than 5%. At the
end of the contract you find that 1-year LIBOR is 4.5%. What is the appropriate cash flow?
a.
the bank pays you $500,000
b.
you pay the bank $500,000
c.
the bank pays you 478,469
d.
you pay the bank 478,469
66. You are looking to hedge a position and you require that the hedge that you take on be extremely
liquid. Therefore you
a.
look to the forward market to hedge.
b.
look to the futures market to hedge.
c.
both of the above are extremely liquid
d.
none of the above are very liquid
67. You are looking at the open interest on a futures contract and notice that there are 500 contracts open.
If none of the holders of these contracts are willing to take delivery then what is the minimum number
of contracts that must be bought or sold by the expiration date of the contract?
a.
0 contracts
b.
250 contracts
c.
500 contracts
d.
1,000 contracts
68. Which of the following assets would probably not lend itself to a futures contract?
a.
paper
b.
water
c.
real estate
d.
microchips
69. You have a long futures position on an asset with a settlement price of $30.00 and a contract expiration
date of 6-months from now. If the settlement price of the contact is $30.08 tomorrow, then what cash
flow will take place if you assume that the initial margin was zero?
a.
all cash settlements will take place 6-months from now
b.
you will receive $.08 per contract
c.
you will pay $.08 per contract
d.
there is not enough information to determine
70. You initially entered into 6 long pork belly positions in the futures market. You subsequently went
long another 3 contracts and then went short 4 contracts. Which of the following is correct? Assume
that all of the contracts have the same settlement price and settlement date.
a.
if you do nothing more then you must take delivery on 5 pork belly contracts
b.
if you do nothing more then you must deliver 5 pork belly contracts
c.
if you do nothing more then you must take delivery on 9 pork belly contracts
d.
if you do nothing more then you must deliver 4 pork belly contracts
71. The basis on a 1-year futures contract is 52 points. If spot prices do not move and the risk-free term
structure of interest rates remains flat and also does not move, then what should be the basis 1-week
before expiration?
a.
1 point
b.
7 points
c.
10 points
d.
52 points
72. You are bidding on a contract in a foreign currency and you are not sure if you will win the bid.
However, the analysis in your bid will be flawed if the foreign currency exchange rate changes
between now and when you know whether you have won the contract. The best course of action to
hedge your position is
a.
long a currency futures contract.
b.
short a currency futures contract.
c.
purchase an option to sell foreign currency for your currency.
d.
sell an option to sell foreign currency for your currency.
73. Your firm has issued $100,000,000 bonds with a fixed cost of 10% to the firm. In addition, the firm
has entered into a contract to pay a bank LIBOR + .5% while the bank pays the firm 8.5%, with both
notional amounts also being $100,000,000. What is the total cost to your firm for the $100,000,000
borrowing?
a.
LIBOR + 1%
b.
LIBOR – 1%
c.
LIBOR + 2%
d.
LIBOR – 2%
74. The Bell Company has issued floating interest rate bonds whereby Bell pays LIBOR + 2% on
$50,000,000 notional value. Bell enters into a swap agreement where Bell receives LIBOR – 3% from
a bank but pays 2% to the bank, both also on a $50,000,000 notional value. What is Bell’s net interest
cost on the borrowing?
a.
2%
b.
5%
c.
7%
d.
LIBOR – 3%
75. You are currently borrowing $100,000,000 based upon a floating rate of LIBOR + 1%. You would like
to borrow the same amount with a fixed rate of 7%. Which interest rate swap will achieve that end?
a.
receive LIBOR and pay 6%
b.
receive (LIBOR +2%) and pay 8%
c.
receive (LIBOR +2%) and pay 9%
d.
a and b above
76. Currently the Euro is trading at €/$ 0.7206; if the current anticipated inflations are 4% (U.S) and 2.3%
(Euro) over the next year what is the fair one-year forward price? (€/$)
a.
0.709
b.
0.704
c.
0.693
d.
0.733
77. Currently the Brazilian Real is trading at R/$ 1.7531; if the current anticipated inflations are 4% (U.S)
and 7.3% (Brazil) over the next year what is the fair one-year forward price? (R/$)
a.
1.686
b.
1.699
c.
1.809
d.
1.634
78. Emma plans to buy four-month Treasury Bills in two months. Currently the price on six-month
Treasury Bills is $975,568 per million. The risk-free rate is 5.4%. What is the fair forward price per
$1 million?
a.
$981,477
b.
$1,038,347
c.
$1,011,398
d.
$993,822
79. Roxy plans to buy four-month Treasury Bills in eight months. Currently the price on
twelve-month Treasury Bills is $962,456 per million. The risk-free rate is 5.2%. What is the fair
forward price per $1 million?
a.
$983,193
b.
$995,538
c.
$1,012,504
d.
$1,012,504
80. Louis plans to buy two-month Treasury Bills in four months. Currently the price on six-month
Treasury Bills is $962,456 per million. The risk-free rate is 5.2%. What is the fair forward price per
$1 million?
a.
$1,007,459
b.
$1,042,088
c.
$1,016,007
d.
$995,114
81. Consider a forward contract to buy a ten-year bond in one year; currently the eleven-year bond has a
coupon rate of 10%, paid semi-annually with a price of $1,050. The current and effective risk-free
rate of interest is 4%. What is the fair forward price?
a.
$991.01
b.
$992.04
c.
$1,092.04
d.
$1,009.62
82. Consider a forward contract to buy a ten-year bond in one year; currently the eleven-year bond has a
coupon rate of 6%, paid semi-annually with a price of $980. The current and effective risk-free rate
of interest is 5%. What is the fair forward price?
a.
$1,029.05
b.
$969.05
c.
$933.33
d.
$968.26
83. Consider a forward contract to buy a ten-year bond in one year; currently the eleven-year bond has a
coupon rate of 7%, paid semi-annually with a price of $1,060. The current and effective risk-free rate
of interest is 5%. What is the fair forward price?
a.
$1,113.05
b.
$1,042.14
c.
$1,043.05
d.
$1,009.52