Chapter 9
Derivatives: Futures, Options, and Swaps
Conceptual and Analytical Problems
1. An agreement to lease a car can be thought of as a set of derivative contracts.
Describe them. (LO2)
Answer: When someone leases a car, he or she agrees to make a series of fixed
2. How is entering into a forward contract similar to barter? Can you think of costs
contracts? (LO2)
Answer: As in barter, when you engage in a forward contract, you must establish a
“double coincidence of wants;” that is, you must find someone who “has what you
involve default risk that is reduced when a centralized clearinghouse is the
counterparty.
3. In spring 2002, an electronically traded futures contract on the stock index, called an
system. Why might someone introduce a futures contract with these properties?
(LO1)
Answer: The size of the contract allows small investors to purchase it. The fact that
also makes it more convenient for foreign investors to trade the contracts.
4. A hedger buys a futures contract, taking a long position in the wheat futures market.
an arrangement. (LO1)
Answer: The hedger has taken the long position, promising to purchase the wheat at a
maker of breakfast cereals, might enter into such a transaction.
5. A futures contract on a payment of $250 times the Standard and Poor’s’ 500 Index is
between the buyer and the seller. Who are the hedgers and who are the speculators in
the S&P 500 futures market? (LO1)
Answer: Hedgers are investors who own funds composed of stocks from the S&P
they expect the market to fall, and buy futures if they expect the market to rise.
6. Explain why trading derivatives on centralized exchanges rather than in
over-the-counter markets helps to reduce systemic risk. (LO1)
Answer: The presence of a centralized counterparty (CCP) increases transparency, as
to the weakness of any one participant.
pay, allowing for a timely resolution of the problem and the avoidance of knock-on
effects.
7. What are the risks and rewards of writing and buying options? Are there any
of a case in which you own shares of the stock on which you are considering writing
a call.) (LO3)
Answer: Because option buyers incur no obligations, their losses are limited to the
is insured against these potential losses and issuing a call option is not very risky.
8. Suppose XYZ Corporation’s stock price rises or falls with equal probability by $20
at $100 when the option is purchased? (LO3)
Answer:
To calculate the time value of the option, list all the possible outcomes for the stock
price movement and identify those where the price goes up. If the stock price falls,
the option will not be exercised.
Month 1 Month 2 Month 3 Total
+20 +20 +20 +60
-20 -20 -20 -60
-20 -20 +20 -20
Each of the outcomes is equally likely and so occurs 1/8 of the time. Focusing on the
first four where the price goes up,
9. *Why might a borrower who wishes to make fixed interest rate payments and who
has access to both fixed- and floating-rate loans still benefit from becoming a party to
a fixed-for-floating interest rate swap? (LO4)
Answer: If the company has a comparative advantage in borrowing in the floating
rate market, it can reduce its overall interest costs by borrowing at a floating interest
directly from the fixed rate market.
10. Concerned about possible disruptions of the supply of oil from the Middle East, the
increase in the price of jet fuel. What tools could the CFO use to hedge this risk?
(LO3)
Answer: The CFO could buy oil futures contracts, giving him or her a long position in
the expiration date of the option.
11. *How does the existence of derivatives markets enhance an economy’s ability to
grow? (LO1)
Answer: The existence of derivative markets increases the economy’s capacity to
be allocated efficiently, hindering the ability of the economy to grow.
12. Credit-default swaps provide a means to insure against default risk and require the
posting of collateral by buyers and sellers. Explain how these “safe-sounding”
derivative products contributed to the 2007-2009 financial crisis? (LO4)
Answer: Credit default swaps (CDS) are traded over the counter and financial
institutions do not report their CDS purchases and sales. This contributed to a lack of
making the system vulnerable to the collapse of one institution.
During the 2007-2009 crisis, AIG was a large player in the market for credit default
financial system as a whole and prompting the intervention of the Federal Reserve.
13. What kind of an option should you purchase if you anticipate selling $1 million of
Treasury bonds in one year’s time and wish to hedge against the risk of interest rates
rising? (LO3)
Answer: You could purchase a put option that gives you (as the holder) the right but
rates rise and so the price of the bonds falls, you can exercise the option and sell the
14. You sell a bond futures contract and, one day later, the clearinghouse informs you that
that day? (LO2)
Answer: Interest rates have risen. This reduced the price of the bonds and so as the
15. You are completely convinced that the price of copper is going to rise significantly
(LO2)
Answer: You should buy as many one-year copper futures contracts as you can afford.
This will depend on the margin payment required. As the margin payment is a
copper.
16. Suppose you have $8,000 to invest and you follow the strategy you devised in
is $8,000. (LO2)
a. Calculate your return if copper prices rise to $3.10 a pound.
b. How does this compare with the return you would have made if
c. Compare the risk involved in each of these strategies.
Answer:
a. With $8,000, you can afford to purchase one copper futures contract. At $3 a
posted. This represents a return of 31.25% on your investment.
b. If you purchased copper directly at $3 a pound, you could have afforded 2,667
c. Speculating in the futures market can bring high returns (in this case returns
almost ten times as large), but, as usual, these high returns come at the cost of
incorrect and the price of copper fell to $2.90. You would have lost $2,500 over
the year. If you were very unfortunate and the price of copper fell to $2.65, you
would have wiped out your entire $8,000 and a bit more as well. In comparison, if
you bought the copper at $3 and after a year you sold it at $2.90, you would have
17. Suppose you were the manager of a bank that raised most of its funds from short-term
could you use interest-rate swaps to hedge against the interest-rate risk you face?
(LO4)
Answer: Given that you make interest payments based on short-term interest rates and
receive remain the same.
You could hedge against this risk by entering into a fixed-for-floating interest rate
banking business.
18. * The table below shows the yields on the fixed and floating borrowing choices
should borrow in the market they do not want and then enter into a fixed-for-floating
interest-rate swap. (LO4)
Fixed Rate Floating Rate
Note: LIBOR, which stands for the London Interbank Offered Rate, is a floating
interest rate.
Answer: Possible pairs: A and C or B and C. (As A and B both want floating, they
A versus C:
A has a 3% advantage over C in the fixed rate market and a 1% advantage in the
floating rate market. Therefore, A has a comparative advantage in the fixed rate
swap to exchange the exposures.
B versus C:
C has a comparative advantage in the fixed rate market and wants fixed rate exposure.
19. * Suppose, prior to the European financial crisis, you were considering investing in
investment? (LO1,LO4)
Answer: Core Principle 2 states that risk requires compensation, so it is likely that
you are attracted by a higher yield available on Greek Government bonds compared
investment might warrant it.
20. You and a colleague both follow the movements of the VIX, an index based on
you disagree? (LO3)
Answer: While you agree with your colleague that low levels of implied volatility
causing risky assets to become mispriced and possibly destabilizing the financial
system when prices correct.