52) An option that gives the owner the right to sell a financial instrument at the exercise price
within a specified period of time is a(n) ________.
A) call option
B) put option
C) American option
D) European option
53) A call option gives the owner the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
54) A put option gives the owner the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
55) A call option gives the seller the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
56) A put option gives the seller the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
57) If you buy an option to buy Treasury futures at 115, and at expiration the market price is 110,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
58) If you buy an option to sell Treasury futures at 115, and at expiration the market price is 110,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
59) If you buy an option to buy Treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
60) If you buy an option to sell Treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
61) The main advantage of using options on futures contracts rather than the futures contracts
themselves is that interest-rate risk is
A) controlled while preserving the possibility of gains.
B) controlled while removing the possibility of losses.
C) not controlled but the possibility of gains is preserved.
D) not controlled but the possibility of gains is lost.
62) The main reason to buy an option on a futures contract rather than the futures contract itself
is
A) to reduce transaction cost.
B) to preserve the possibility for gains.
C) to limit losses.
D) to remove the possibility for gains.
63) The main disadvantage of futures contracts as compared to options on futures contracts is
that futures
A) remove the possibility of gains.
B) increase the transactions cost.
C) are not as effective a hedge.
D) do not remove the possibility of losses.
64) All other things held constant, premiums on put options will increase when the
A) exercise price increases.
B) volatility of the underlying asset falls.
C) term to maturity increases.
D) A and C are both true.
65) All other things held constant, premiums on call options will increase when the
A) exercise price falls.
B) volatility of the underlying asset falls.
C) term to maturity decreases.
D) futures price increases.
66) All other things held constant, premiums on both put and call options will increase when the
A) exercise price increases.
B) volatility of the underlying asset increases.
C) term to maturity decreases.
D) futures price increases.
67) An increase in the volatility of the underlying asset, all other things held constant, will
________ the option premium.
A) increase
B) decrease
C) not affect
D) Not enough information is given.
68) An increase in the exercise price, all other things held constant, will ________ the premium
on call options.
A) increase
B) decrease
C) not affect
D) Not enough information is given.
69) If a bank manager wants to protect the bank against losses that would be incurred on its
portfolio of Treasury securities should interest rates rise, he could ________ options on financial
futures.
A) buy put
B) buy call
C) sell put
D) sell call
70) A financial contract that obligates one party to exchange a set of payments it owns for
another set of payments owned by another party is called a ________.
A) cross hedge
B) cross call option
C) cross put option
D) swap
71) A swap that involves the exchange of a set of payments in one currency for a set of payments
in another currency is a(n) ________.
A) interest-rate swap
B) currency swap
C) swaption
D) notional swap
72) A swap that involves the exchange of one set of interest payments for another set of interest
payments is called a(n) ________.
A) interest-rate swap
B) currency swap
C) swaption
D) notional swap
73) If Second National Bank has more rate-sensitive assets than rate-sensitive liabilities, it can
reduce interest-rate risk with a swap which requires Second National to
A) pay a fixed rate while receiving a floating rate.
B) receive a fixed rate while paying a floating rate.
C) both receive and pay a fixed rate.
D) both receive and pay a floating rate.
74) If Second National Bank has more rate-sensitive liabilities than rate-sensitive assets, it can
reduce interest-rate risk with a swap which requires Second National to
A) pay a fixed rate while receiving a floating rate.
B) receive a fixed rate while paying a floating rate.
C) both receive and pay a fixed rate.
D) both receive and pay a floating rate.
75) If a bank has a gap of -$10 million, it can reduce its interest-rate risk by
A) paying a fixed rate on $10 million and receiving a floating rate on $10 million.
B) paying a floating rate on $10 million and receiving a fixed rate on $10 million.
C) selling $20 million fixed-rate assets.
D) buying $20 million fixed-rate assets.
76) One advantage of using swaps to eliminate interest-rate risk is that swaps
A) are less costly than futures.
B) are less costly than rearranging balance sheets.
C) are more liquid than futures.
D) have better accounting treatment than options.
77) The disadvantage of swaps is that
A) they lack liquidity.
B) it is difficult to arrange for a counterparty.
C) they suffer from default risk.
D) they are all of the above.
78) As compared to a default on the notional principle, a default on a swap
A) is more costly.
B) is about as costly.
C) is less costly.
D) may cost more or less than default on the notional principle.
79) Intermediaries are active in the swap markets because
A) they increase liquidity.
B) they reduce default risk.
C) they reduce search cost.
D) all of the above are true.
80) A valid concern about financial derivatives is that
A) they allow financial institutions to increase their leverage.
B) they are too sophisticated because they are so complicated.
C) the notional amounts can greatly exceed a financial institution’s capital.
D) all of the above are valid concerns.
E) none of the above are valid concerns.
81) The biggest danger of financial derivatives occurs
A) when notional amounts exceed a bank’s capital.
B) when financial market prices and rates are highly volatile.
C) in the trading activities of financial institutions.
D) in the large amount of credit exposure.
82) The use of financial derivatives by financial institutions to hedge can decrease risk.
However, they can also increase risk. Which of the following examples illustrates this?
A) Financial derivatives allow financial institutions to increase their leverage.
B) Some institutions such huge amounts of derivatives that the amounts exceed capital.
C) All of the above are valid examples.
D) None of the above are valid examples.
83) Future options are particularly useful for offsetting risk created when a bank ________.
A) extends option-like commitments to bank customers
B) has the right to borrow at a fixed-rate in the future
C) has a loan portfolio of primarily fixed-rate loan products
D) is involved in gold and other inflation-hedging instruments
84) If a financial institution uses stock index futures to completely hedge the systematic
component of its stock portfolio, the resulting portfolio will have a beta close to ________.
A) 0.00
B) 1.00
C) 2.00
D) 0.50.
24.2 True/False
1) A forward contract is more flexible than a futures contract.
2) Futures contracts are standardized.
3) A long contract obligates the holder to sell securities in the future.
4) A short contract obligates the holder to sell securities in the future.
5) One problem with a futures contract is finding a counterparty.
6) Futures contracts are subject to default risk.
7) Futures trading is regulated by the Commodity Futures Trading Commission.
8) Open interest allows investors to change the interest rate on futures contracts.
9) To reduce the interest-rate risk of holding a portfolio of bonds, Treasury bond futures
contracts should be bought.
10) To reduce foreign exchange risk from selling goods to a foreign country, futures contracts
should be sold.
11) An option that gives the holder the right to buy an asset in the future is a put.
12) Option premiums increase as the term to maturity increases.
13) Option premiums fall as the volatility of the underlying asset falls.
14) Using options to control interest-rate risk reduces the chance of a loss but increases the
chance of a gain.
15) One advantage of using options to hedge is that the accounting transaction will never require
the firm to show large unrecognized losses.
16) Interest-rate swaps involve the exchange of a set of payments in one currency for a set of
payments in another.
17) Currency swaps involve the exchange of a set of payments on one currency for a set of
payments in another.
18) If Friendly Finance Company has more rate-sensitive assets than rate-sensitive liabilities, it
may reduce risk with a swap.
19) Interest-rate swaps are more liquid than futures contracts.
20) Intermediaries add value to the swap markets by reducing default risk.
21) The global financial crisis illustrates that derivatives cannot be used to hedge — financial
institutions should be barred from using them in any form.
24.3 Essay
1) Distinguish between forward and futures contracts.
2) Why have the futures markets grown so rapidly in recent years?
3) Explain how a short hedge could be used to hedge a Treasury portfolio against interest-rate
risk.
4) Explain how a long hedge could be used to protect a bank from the risk that interest rates
could rise before a loan is funded.
5) How would a firm use exchange rate futures to lock in current exchange rates?
6) Explain how a swap could be used to reduce interest-rate risk for a bank with more rate-
sensitive assets than rate-sensitive liabilities.
7) Define and distinguish between call options and put options.
8) Explain how option contracts could be used to protect against losses in portfolio value that
may occur as interest rates increase.
9) Explain the advantages of protecting against interest-rate risk using options rather than futures
contracts.
10) Discuss the advantages of using swaps to protect against interest-rate risk rather than
restructuring the balance sheet.
11) Discuss the challenges regulators face in controlling the use of derivatives by financial
institutions.
12) Explain the difference between a macro hedge and a micro hedge for a financial institution.