Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 7 Derivatives and Derivative Markets
7.1 Derivatives, Hedging, and Speculating
1) In derivative markets, trade takes place in
A) assets such as bonds or common stock that derive their value from the value of the companies
which issue them.
B) assets whose rates of returns must be derived from information published in financial tables.
C) assets that derive their value from underlying assets.
D) assets which are not allowed to be traded on organized exchanges.
2) Derivative instruments are
A) assets such as bonds or common stock that derive their value from the value of the companies
which issue them.
B) assets whose rates of returns must be derived from information published in financial tables.
C) assets which derive their value from underlying assets.
D) computers which display real-time financial information.
3) Which of the following is NOT a benefit of derivatives?
A) risk sharing
B) guaranteed minimum profit
C) liquidity
D) information services
4) Suppose you are a manager for a company that produces grape jelly. Which of the following is
the best way for you to reduce your risk?
A) acquire a derivative that increases in value if grape prices increase
B) acquire a derivative that increases in value if grape jelly prices increase
C) sell a derivative that increases in value if grape prices increase
D) sell a derivative that increases in value if grape jelly prices increase
5) The most important derivative instruments are
A) futures, options, and swaps.
B) common and preferred stocks.
C) corporate bonds.
D) government bonds.
6) Hedgers are primarily interested in
A) betting on anticipated changes in prices.
B) reducing their exposure to the risk of price fluctuations.
C) increasing market liquidity.
D) reducing the spread between bid and ask prices on bonds.
7) Speculators are primarily interested in
A) betting on anticipated changes in prices.
B) reducing their exposure to the risk of price fluctuations.
C) increasing market liquidity.
D) reducing the spread between bid and ask prices on bonds.
8) Profits from speculation arise because of
A) the spread between the bid and ask prices on bonds.
B) the illiquidity of markets for derivative instruments.
C) the high information costs in markets for derivative instruments.
D) disagreements among traders about future prices of a commodity or financial instrument.
9) Speculators in derivatives markets
A) reduce the efficiency of these markets.
B) are acting contrary to U.S. securities laws.
C) accept risk transferred to them by hedgers.
D) reduce the liquidity of these markets.
10) How does hedging affect the flow of funds in the financial system?
A) It reduces it since it is a sign that investors do not like risk.
B) It reduces it because it increases risk by encouraging speculation.
C) It increases it because it reduces risk thus encouraging more people to make financial
investments.
D) It increases it by encouraging more speculation.
11) Describe two useful purposes served by speculators in derivatives markets.
7.2 Forward Contracts
1) Using forward transactions allows
A) holders of common stock to lock in future dividend payments.
B) the federal government to stabilize fluctuations in tax receipts.
C) corporations to reduce problems arising from future fluctuations in their dividend payments.
D) both buyers and sellers to reduce risks associated with price fluctuations.
2) Spot transactions
A) involve immediate settlement.
B) may only take place in face-to-face trading.
C) take place on-the-spot, rather than on an organized exchange.
D) are relatively unimportant in financial markets.
3) Forward transactions
A) allow savers and borrowers to conduct a transaction now and settle in the future.
B) allow savers and borrowers to postpone a transaction from now to the future.
C) always involve increased risk compared with spot transactions.
D) may not be conducted on organized exchanges.
4) Forward transactions would be useful to
A) a government wanting to know the size of its future debt.
B) a household wanting to reduce its future tax liability.
C) a business wanting to know the cost of its funds on future loans.
D) a business wanting to expand its operations in overseas markets.
5) Forward transactions originated in the market for
A) common stock.
B) corporate bonds.
C) government bonds.
D) agricultural and other commodities.
6) Forward transactions
A) provide little risk sharing.
B) are very liquid.
C) have information problems.
D) are widely used by sellers of commodities, but rarely used by buyers of commodities.
7) Forward contracts are often illiquid because
A) any capital gains on them are heavily taxed, making investors reluctant to sell them.
B) government regulation has not provided for a secondary market in them.
C) they generally contain terms specific to the particular buyer and seller.
D) the brokerage fees involved in buying and selling them are very high.
8) The existence of counterparty risk
A) has no effect on the contracting parties.
B) is disallowed under current government regulations.
C) results in information costs for buyers and sellers when analyzing the potential
creditworthiness of potential trading partners.
D) reduces the risk introduced by forward contracts.
9) Forward transactions
A) provide substantial liquidity.
B) entail small information costs.
C) provide risk sharing.
D) provide reduced tax payments.
10) Forward contracts
A) are highly liquid.
B) entail small information costs.
C) provide little risk sharing.
D) are subject to default risk.
11) Why are forward contracts typically illiquid?
12) What are the information costs associated with forward contracts?
7.3 Futures Contracts
1) A futures contract is
A) an agreement that specifies the delivery of a commodity or financial instrument at an agreed-
upon future date at a currently agreed-upon price.
B) an agreement that specifies the delivery of a commodity or financial instrument at an agreed-
upon future date, with the price to be negotiated at the time of delivery.
C) an agreement that specifies the delivery of a commodity or financial instrument at a currently
agreed-upon price, with date of delivery to be negotiated subsequently.
D) an agreement that specifies the delivery of a commodity or financial instrument, with the
price and date of delivery to be negotiated subsequently.
2) The elimination of riskless profit opportunities is known as
A) arbitrage.
B) options.
C) swaps.
D) liquidity.
3) If you look at the financial page listings for futures contracts and find that futures prices on
Treasury bonds are falling over a particular time period, futures market investors must expect
that
A) Treasury bond prices will be higher in the future.
B) Treasury bond yields will be higher in the future.
C) Treasury bond yields will be lower in the future.
D) futures prices will rise again at the end of the period.
4) Standardization of derivative contracts
A) increases their liquidity.
B) is the rule with respect to contracts whose underlying asset is a financial security, but not for
contracts whose underlying asset is a commodity.
C) is the rule with respect to contracts whose underlying asset is a commodity, but not for
contracts whose underlying asset is a financial asset.
D) has been proposed many times by financial analysts, but has not yet been carried out by the
SEC.
5) In recent decades,
A) trading in financial futures declined in importance relative to trading in agricultural and
mineral commodities futures.
B) trading in financial futures increased in importance relative to trading in agricultural and
mineral commodities futures.
C) trading in agricultural and commodities futures was discontinued.
D) trading in financial futures was discontinued.
6) Currently,
A) trading futures contracts on agricultural and mineral commodities makes up a majority of all
trading.
B) trading in financial futures involves more transactions than trading in commodity futures.
C) futures trading is allowed only for financial assets.
D) futures trading is allowed only for commodities.
7) The buyer of a futures contract
A) assumes the short position.
B) assumes the long position.
C) may not sell the contract without the permission of the original seller.
D) has the obligation to deliver the underlying financial instrument at the specified future date.
8) The buyer of a futures contract
A) assumes the short position.
B) has the obligation to deliver the underlying financial instrument at the specified date.
C) has the obligation to receive the underlying financial instrument at the specified future date.
D) may, at his or her option, deliver or receive the underlying financial instrument at the
specified date.
9) The seller of a futures contract
A) assumes the short position.
B) assumes the long position.
C) has the obligation to receive the underlying financial instrument at the specified future date.
D) is expecting the price of the underlying financial instrument to rise.
10) The seller of a futures contract
A) assumes the long position.
B) has the obligation to deliver the underlying financial instrument at the specified date.
C) has the obligation to receive the underlying financial instrument at the specified future date.
D) may, at his or her option, deliver or receive the underlying financial instrument at the
specified date.
11) Futures trading has traditionally been dominated by
A) the New York Stock Exchange.
B) the Chicago Board of Trade and the Chicago Mercantile Exchange.
C) the London Stock Exchange.
D) the Omaha Grain Exchange.
12) Which of the following financial futures contracts are traded in the United States?
A) Interest rates
B) Stock indexes
C) Currencies
D) All of the above
13) Financial futures contracts are regulated by
A) the Commodity Futures Trading Commission.
B) the Federal Trade Commission.
C) the Interstate Commerce Commission.
D) the Options and Futures Commission.
14) The role of the Commodity Futures Trading Commission is to
A) set the prices of futures contracts.
B) operate the Chicago Mercantile Exchange.
C) operate the Chicago Board of Trade.
D) monitor potential price manipulation in futures trading.
15) The initial deposit required by a buyer or seller of a futures contract is known as
A) credit.
B) margin requirement.
C) debit.
D) marking.
16) Marking to market involves
A) changing the futures price to the spot price each day.
B) engaging in arbitrage so as to reduce the risk involved with futures contracts.
C) crediting or debiting the margin account based on the net change in the value of the futures
contract.
D) updating the futures price after the market closes each day.
17) The futures price
A) reflects traders’ expectations of the spot price on the day of delivery.
B) is always above the spot price on the day of delivery.
C) is always below the spot price on the day of delivery.
D) is always equal to the spot price at every point in time.
18) If market participants believe that the wheat crop is likely to be unusually small,
A) the spot price of wheat is likely to be above the futures price of wheat.
B) the spot price of wheat is likely to be below the futures price of wheat.
C) it will not be possible to find a seller of a futures contract in wheat.
D) it will not be possible to find a buyer of a futures contract in wheat.
19) As the time of delivery in a futures contract gets closer
A) the futures price gets closer to the spot price.
B) the futures price generally rises further above the spot price.
C) the futures price generally falls further below the spot price.
D) the futures and spot prices remain the same as they were when the contract was first created.
20) On the day of delivery
A) the spot price will equal the futures price.
B) the spot price will be greater than the futures price by an amount equal to the current interest
rate times the futures price.
C) the futures price will be greater than the spot price by an amount equal to the current interest
rate times the spot price.
D) there is no necessary relation between the spot price and the futures price.
21) If you buy a futures contract for U.S. Treasury bills and on the delivery date the interest rate
on T-bills is lower than you expected, you will have
A) lost money on your long position.
B) gained money on your long position.
C) lost money on your short position.
D) gained money on your short position.
22) If you sell a futures contract for U.S. Treasury bills and on the delivery date the interest rate
of T-bills is higher than you expected, you will have
A) lost money on your long position.
B) gained money on your long position.
C) lost money on your short position.
D) gained money on your short position.
23) Marking to market refers to
A) the determination of the prices of options contracts by the interaction of demand and supply.
B) the determination of the prices of futures contracts by the interaction of demand and supply.
C) the settlement of gains and losses on futures contracts each day.
D) the settlement of gains and losses on forward contracts each day.
24) The terms of futures contracts traded in the United States are
A) standardized as to amount or value, but not as to location or time of delivery.
B) standardized as to location or time of delivery, but not as to amount or value.
C) not standardized, but are determined entirely on the basis of the agreement entered into by the
buyer and seller.
D) standardized as to amount or value and as to location or time of delivery.
25) Futures trading practices in the United States are regulated by
A) the Chicago Board of Trade.
B) the Chicago Mercantile Exchange.
C) the Commodities Futures Trading Commission.
D) the Board of Futures Trading.
26) If the price of a futures contract increases, then
A) the exchange will collect the amount of the increase from the seller of the contract and
transfer it to the account of the buyer of the contract.
B) the exchange will collect the amount of the increase from the buyer of the contract and
transfer it to the account of the seller of the contract.
C) the exchange will collect the amount of the increase from both the buyer and the seller and
place it in escrow until the delivery date.
D) the additional funds will be required from either the buyer or the seller until the delivery date.
27) Which of the following statements about the presence of speculators in futures markets is
correct?
A) Their main objective is to reduce their exposure to risk.
B) They aid hedgers by increasing the liquidity in futures markets.
C) They make it difficult for hedgers to find someone to take the opposite side of their positions.
D) Once a futures market participant is known to be a speculator he or she is no longer allowed
to participate in the market.
28) A lender who is worried that its cost of funds might rise during the term of a loan it has made
can hedge against this rise by
A) buying futures contracts on Treasury bills.
B) selling futures contracts on Treasury bills.
C) buying call options on Treasury bills.
D) increasing the amount of money which it lends.