Chapter 25

Derivatives and Hedging Risk

 

Multiple Choice Questions

 

1. A derivative is a financial instrument whose value is determined by: 

 

A. a regulatory body such as the FTC.

B. a primitive or underlying asset.
C.  hedging a risk.
D. hedging a speculation.
E.  None of these.
 
2. Derivatives can be used to either hedge or speculate. These actions: 
 

A. increase risk in both cases.

B. decrease risk in both cases.
C.  spread or minimize risk in both cases.
D. offset risk by hedging and increase risk by speculating.
E.  offset risks by speculating and increase risk by hedging.
 
3. A forward contract is described by: 
 

A. agreeing today to buy a product at a later date at a price to be set in the future.
B. agreeing today to buy a product today at its current price.
C.  agreeing today to buy a product at a later date at a price set today.
D. agreeing today to buy a product if and only if its price rises above the exercise price today at its current
price.
E.  None of these.
 
4. The buyer of a forward contract: 
 

A. will be taking delivery of the good(s) today at today's price.

B. will be making delivery of the good(s) at a later date at that date's price.
C.  will be making delivery of the good(s) today at today's price.
D. will be taking delivery of the good(s) at a later date at pre-specified price.
E.  Both will be taking delivery of the good(s) today at today's price or will be taking delivery of the good(s)
at a later date at pre-specified price.
 

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5. The main difference between a forward contract and a cash transaction is: 
 

A. only the cash transaction creates an obligation to perform.

B. a forward is performed at a later date while the cash transaction is performed immediately.
C.  only one involves a deliverable instrument.
D. neither allows for hedging.
E.  None of these.
 
6. Futures contracts contrast with forward contracts by: 
 

A. trading on an organized exchange.

B. marking to the market on a daily basis.
C.  allowing the seller to deliver any day over the delivery month.
D. All of these.
E.  None of these.
 
7. Which of the following is true about the user of derivatives? 
 

A. Derivatives usually appear explicitly in the financial statements.

B. Academic surveys account for much of our knowledge of corporate derivatives use.
C.  Smaller firms are more likely to use derivatives than large firms.
D. The most frequently used derivatives are commodity and equity futures.
E.  None of these are true.
 
8. Which of the following terms is not part of a forward contract? 
 

A. Making delivery
B. Taking delivery
C.  Delivery instrument
D. Cash transaction
E.  None of these.
 
9. Duration is a measure of the: 
 

A. yield to maturity of a bond.

B. coupon yield of a bond.
C.  price of a bond.
D. effective maturity of a bond.
E.  All of these.
 

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10. A swap is an arrangement for two counterparties to: 
 

A. exchange cash flows over time.

B. permit fluctuation in interest rates.
C.  help exchange markets clear.
D. All of these.
E.  None of these.
 
11. LIBOR stands for: 
 

A. Lausanne Interest Basis Offered Rate.

B. London International Offered Rate.
C.  London Interbank Offered Rate.
D. London Interagency Offered Rate.
E.  None of these.
 
12. A futures contract on gold states that buyers and sellers agree to make or take delivery of an ounce of gold
for $400 per ounce. The contract expires in 3 months. The current price of gold is $400 per ounce. If the
price of gold rises and continues to rise every day over the 3 month period, then when the contract is settled,
the buyer will _____ and the seller will _____. 
 

A. lose; gain
B. gain; lose
C.  gain; break even
D. gain; gain
E.  lose; lose
 
13. A potential disadvantage of forward contracts versus futures contracts is: 
 

A. the extra liquidity required to cover the potential outflows that occur prior to delivery and caused by
marking to market.
B. the incentive for a particular party to default.
C.  that the buyers and sellers don't know each other and never meet.
D. All of these.
E.  Both the extra liquidity required to cover the potential outflows that occur prior to delivery and caused by
marking to market; and that the buyers and sellers don't know each other and never meet.
 
14. A farmer with wheat in the fields and who uses the futures market to protect a profit is an example of: 
 

A. a long hedge.

B. a short hedge.
C.  selling futures to guard against a potential loss.
D. Both a long hedge and selling futures to guard against a potential loss.
E.  Both a short hedge and selling futures to guard against a potential loss.
 

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15. A miller who needs wheat to mill to flour uses the futures market to protect a profit by: 
 

A. a long hedge to take delivery.

B. a short hedge to deliver.
C.  buying futures to guard against a potential loss.
D. Both a long hedge to take delivery; and buying futures to guard against a potential loss.
E.  Both a short hedge to deliver; and buying futures to guard against a potential loss.
 
16. A chocolate company which uses the futures market to lock in the price of cocoa to protect a profit is an
example of: 
 

A. a long hedge.

B. a short hedge.
C.  purchasing futures to guard against a potential loss.
D. Both a long hedge; and purchasing futures to guard against a potential loss.
E.  Both a short hedge; and purchasing futures to guard against a potential loss.
 
17. If the producer of a product has entered into a fixed price sale agreement for that output, the producer faces: 
 

A. a nice steady profit because the output price is fixed.

B. an uncertain profit if the input prices are volatile. This risk can be reduced by a short hedge.
C.  an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
D. a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
E.  a modest profit if the input prices are stable. This risk can be reduced by a short hedge.
 
18. You hold a forward contract to take delivery of U.S. Treasury bonds in 9 months. If the entire term structure
of interest rates shifts down over the 9-month period, the value of the forward contract will have _____ on
the date of delivery. 
 

A. risen
B. fallen
C.  not changed
D. either risen or fallen, depending on the maturity of the T-bond
E.  collapsed
 
19. Two key features of futures contracts that make them more in demand than forward contracts are: 
 

A. futures are traded on exchanges and must be marked to the market.

B. futures contracts allow flexibility in delivery dates and provide a liquid market for netting positions.
C.  futures are marked to the market and allow delivery flexibility.
D. futures are traded in liquid markets and are marked to the market.
E.  All of these.
 

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20. If rates in the market fall between now and one month from now, the mortgage banker: 
 

A. loses as the mortgages are sold at a discount.

B. gains as the mortgages are sold at a discount.
C.  loses as the mortgages are sold at a premium.
D. gains as the mortgages are sold at a premium.
E.  neither gains nor loses.
 
21. To protect against interest rate risk, the mortgage banker should: 
 

A. buy futures, as this position will hedge losses if rates rise.

B. sell futures, as this position will hedge losses if rates rise.
C.  sell futures, as this position will add to his gains if rates rise.
D. buy futures, as this position will add to his gains if rates rise.
E.  None of these.
 
22. Futures market transactions are used to reduce risk. Risk may not be totally offset if: 
 

A. the two instruments have different maturities.

B. payoff schedules of the two instruments are different.
C.  the volatility of the two instruments are different.
D. the price movements are not perfectly correlated.
E.  All of these.
 
23. Hedging in the futures markets can reduce all risk if: 
 

A. price movements in both the cash and futures markets are perfectly correlated.
B. price movements in both the cash and futures markets have zero correlation.
C.  price movements in both the cash and futures markets are less than perfectly correlated.
D. the hedge is a short hedge, but not a long hedge.
E.  the hedge is a long hedge, but not a short hedge.
 
24. Comparing long-term bonds with short-term bonds, long-term bonds are _____ volatile and therefore
experience _____ price change than short-term bonds for the same interest rate shift. 
 

A. less; less
B. less; more
C.  more; more
D. more; less
E.  more; the same
 

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25. When interest rates shift, the price of zero coupon bonds: 
 

A. are more volatile as compared with short-term bonds of the same maturity.
B. are less volatile as compared with short-term bonds of the same maturity.
C.  are more volatile as compared with long-term bonds of the same maturity.
D. are less volatile as compared with long-term bonds of the same maturity.
E.  Both are more volatile as compared with short-term bonds of the same maturity; and are more volatile as
compared with long-term bonds of the same maturity.
 
26. Duration of a pure discount bond: 
 

A. is equal to its half-life.

B. is less than a zero coupon bond.
C.  is equal to the liabilities hedged.
D. is equal to its maturity.
E.  None of these.
 
27. In percentage terms, higher coupon bonds experience a _______ price change compared with lower coupon
bonds of the same maturity given a change in yield to maturity. 
 

A. greater
B. smaller
C.  similar
D. smaller or greater
E.  None of these.
 
28. A bond manager who wishes to hold the bond with the greatest potential volatility would be wise to hold: 
 

A. short-term, high-coupon bonds.

B. long-term, low-coupon bonds.
C.  long-term, zero-coupon bonds.
D. short-term, zero-coupon bonds.
E.  short-term, low-coupon bonds.
 
29. The duration of a 15 year zero coupon bond priced at $182.70 is: 
 

A. 2.74 years.
B. 15 years.
C.  17.74 years.
D. cannot determine without the interest rate.
E.  None of these.
 

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30. A set of bonds all have the same maturity. Which one has the least percentage price change for given shifts
in interest rates: 
 

A. zero coupon bonds.

B. high coupon bonds.
C.  low coupon bonds.
D. pure discount bonds.
E.  not enough information to determine.
 
31. A financial institution can hedge its interest rate risk by: 
 

A. matching the duration of its assets to the duration of its liabilities.

B. setting the duration of its assets equal to half that of the duration of its liabilities.
C.  matching the duration of its assets, weighted by the market value of its assets with the duration of its
liabilities, weighted by the market value of its liabilities.
D. setting the duration of its assets, weighted by the market value of its assets to one half that of the duration
of the liabilities, weighted by the market value of the liabilities.
 
32. A pure discount bond pays: 
 

A. no coupons, therefore its duration is equal to its maturity.

B. discounted coupons, therefore its duration is greater than its maturity.
C.  level coupons, therefore its duration is equal to its maturity.
D. declining coupons, therefore its duration is less than its maturity.
E.  None of these.
 
33. Duration of a coupon paying bond is: 
 

A. equal to its number of payments.

B. less than a zero coupon bond.
C.  equal to the zero coupon bond.
D. equal to its maturity.
E.  None of these.
 
34. A financial institution has equity equal to one-tenth of its assets. If its asset duration is currently equal to its
liability duration, then to immunize, the firm needs to: 
 

A. decrease the duration of its assets.

B. increase the duration of its assets.
C.  decrease the duration of its liabilities.
D. do nothing, i.e., keep the duration of its liabilities equal to the duration of its assets.
 

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35. If a financial institution has equated the dollar effects of interest rate risk on its assets with the dollar effects
on its liabilities, it has engaged in: 
 

A. a long hedge.

B. a short hedge.
C.  a protected swap.
D. immunizing interest rate risk.
E.  None of these.
 
36. A savings and loan has extremely long-term assets that are currently matched against extremely short-term
liabilities. For this S&L: 
 

A. falling interest rates will decrease the value of its equity.

B. falling interest rates will increase the value of its equity.
C.  rising interest rates will increase the value of its equity.
D. rising interest rates will decrease the value of its equity.
E.  Both falling interest rates will increase the value of its equity; and rising interest rates will decrease the
value of its equity.
 
37. Interest rate and currency swaps allow one party to exchange a: 
 

A. floating interest rate or currency value for a fixed value over the contract term.
B. fixed interest rate or currency value for a lower fixed value over the contract term.
C.  floating interest rate or currency value for a lower floating value over the contract term.
D. fixed interest rate position for a currency position over the contract term.
E.  None of these.
 
38. Exotic derivatives are complicated blends of other derivatives. Some exotics are: 
 

A. inverse floaters.
B. cap and floors.
C.  futures.
D. Both inverse floaters; and cap and floors.
E.  Both cap and floors; and futures.
 
39. An inverse floater and a super-inverse floater are more valuable to a purchaser if: 
 

A. interest rates stay the same.

B. interest rates fall.
C.  interest rates rise.
D. held for a long time.
E.  None of these.
 

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40. If a firm purchases a cap at 10% this will: 
 

A. limit the amount of borrowing to 10% of assets.

B. pay the firm 10% on their purchase.
C.  pay the holder the LIBOR interest above 10%.
D. pay the holder the LIBOR interest below the 10%.
E.  None of these.
 
41. If a firm sells a floor at 6% this will: 
 

A. pay the holder the LIBOR interest below the 6%.

B. pay the firm 6% on their purchase.
C.  pay the holder the LIBOR interest above 6%.
D. limit the amount of borrowing to 6% of assets.
E.  None of these.
 
42. In the practical use of credit default swaps there: 
 

A. is not an organized exchange or template for the agreement.

B. is an organized exchange or template for the agreement.
C.  are laws making them illegal in the United States.
D. are limits to the amount of borrowing of both parties.
E.  None of these.
 
43. Credit default swaps: 
 

A. will pay the holder the LIBOR interest rate.

B. pay the borrower the LIBOR interest rate.
C.  are like insurance against a loss of value if the firm defaults on a bond.
D. limit the amount of borrowing of all parties in the credit default swap.
E.  None of these.
 
44. There are always ___ counterparties in a credit default swap: 
 

A. 0
B. 1
C.  2
D. 3
E.  more than three
 

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45. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the next 5 days the
contract settled at 2.52, 2.57, 2.62, 2.68, and 2.70. You then decide to reverse your position in the futures
market on the fifth day at close. What is the net amount you receive at the end of 5 days? 
 

A. $0.00
B. $2.60
C.  $2.70
D. $2.80
E.  Must know the number of contracts
 
46. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the next 5 days the
contract settled at 2.52, 2.57, 2.62, 2.68, and 2.70. Before you can reverse your position in the futures
market on the fifth day you are notified to complete delivery. What will you receive on delivery and what is
the net amount you receive in total? 
 

A. $2.60; $-0.10
B. $2.60; $0.10
C.  $2.60; $2.70
D. $2.70; $-0.10
E.  $2.70; $2.60
 
47. You bought a futures contract for $2.60 per bushel and the contract ended at $2.70 after several days of
trading with the following close prices each day: $2.52, $2.57, $2.62, $2.68, and $2.70. What would the
mark to market sequence be? 
 

A. -.08, .05, .05, .06, .02

B. .08, -.05, -.05, -.06, -.02
C.  .08, .03, -.02, -.06, -.10
D. -.08, -.03, .02, .06, .10
E.  .10, .06, .02, -.03, -.08
 
48. Suppose you agree to purchase one ounce of gold for $382 any time over the next month. The current price
of gold is $380. The spot price of gold then falls to $377 the next day. If the agreement is represented by a
futures contract marking to market on a daily basis as the price changes, what is your cash flow at the end of
the next business day? 
 

A. $0
B. $3
C.  $5
D. -$3
E.  -$5
 

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49. On March 1, you contract to take delivery of 1 ounce of gold for $415. The agreement is good for any day
up to April 1. Throughout March, the price of gold hit a low of $385 and hit a high of $435. The price
settled on March 31 at $420, and on April 1st you settle your futures agreement at that price. Your net cash
flow is: 
 

A. -$30.
B. -$20.
C.  -$15.
D. $5.
E.  $20.
 
50. A bank has a $50 million mortgage bond risk position which it hedges in the Treasury bond futures markets
at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the hedge? 
 

A. 5
B. 50
C.  500
D. 5,000
E.  50,000
 
51. A mortgage banker had made loan commitments for $10 million in 3 months. How many contracts on
Treasury bonds futures must the banker write or buy? 
 

A. Go short 10.

B. Go short 100.
C.  Go long 10.
D. Go long 100.
E.  None of these.
 
52. The duration of a 2 year annual 10% bond that is selling for par is: 
 

A. 1.00 years.
B. 1.91 years.
C.  2.00 years.
D. 2.09 years.
E.  None of these.
 
53. Firm A is paying $750,000 in interest payments a year while Firm B is paying LIBOR plus 75 basis points
on $10,000,000 loans. The current LIBOR rate is 6.5%. Firm A and B have agreed to swap interest
payments. What is the net payment this year? 
 

A. Firm A pays $750,000 to Firm B

B. Firm B pays $725,000 to Firm A
C.  Firm B pays $25,000 to Firm A
D. Firm A pays $25,000 to Firm B
E.  None of these.
 

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54. A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent annual coupon rate.
The $1,000 face value is returned at maturity. If the effective annual yield for all maturities is 7 percent
annually, what is the current price of the Treasury note? 
 

A. $960.68
B. $986.69
C.  $1,010.35
D. $1,034.40
E.  $1,038.99
 
55. Calculate the duration of a 7-year $1,000 zero-coupon bond with a current price of $399.63 and a yield to
maturity of 14%. 
 

A. 5 years
B. 6 years
C.  7 years
D. 8 years
E.  9 years
 
56. Calculate the duration of a 4-year $1,000 face value bond, which pays 8% coupons annually throughout
maturity and has a yield to maturity of 9%. 
 

A. 3.29 years
B. 3.57 years
C.  3.69 years
D. 3.89 years
E.  4.00 years
 
57. On March 1, you contract to take delivery of 1 ounce of gold for $495. The agreement is good for any day
up to April 1. Throughout March, the price of gold hit a low of $425 and hit a high of $535. The price
settled on March 31 at $505, and on April 1st you settle your futures agreement at that price. Your net cash
flow is: 
 

A. -$30.
B. -$20.
C.  -$15.
D. $10.
E.  $20.
 
58. A bank has a $80 million mortgage bond risk position which it hedges in the Treasury bond futures markets
at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the hedge? 
 

A. 8
B. 80
C.  800
D. 8,000
E.  80,000
 

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59. Suppose you agree to purchase one ounce of gold for $984 any time over the next month. The current price
of gold is $970. The spot price of gold then falls to $960 the next day. If the agreement is represented by a
futures contract marking to market on a daily basis as the price changes, what is your cash flow at the end of
the next business day? 
 

A. $10
B. $5
C.  $0
D. -$5
E.  -$10
 
60. On June 1, you contract to take delivery of 1 ounce of gold for $965. The agreement is good for any day up
to July 1. Throughout June, the price of gold hit a low of $960 and hit a high of $990. The price settled on
June 30 at $980, and on July 1st you settle your futures agreement at that price. Your net cash flow is: 
 

A. -$20.
B. -$15.
C.  -$5
D. $15.
E.  $20.
 
61. A bank has a $100 million mortgage bond risk position which it hedges in the Treasury bond futures
markets at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the
hedge? 
 

A. 10
B. 100
C.  1,000
D. 10,000
E.  100,000
 
62. A mortgage banker had made loan commitments for $20 million in 3 months. How many contracts on
Treasury bonds futures must the banker write or buy? 
 

A. Go short 20.

B. Go short 200.
C.  Go long 20.
D. Go long 200.
E.  None of these.
 
 

Essay Questions
 

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63.

   

Calculate the duration of Tiger State Bank's assets and liabilities. 

 

 
64.

   

What new asset duration will immunize the balance sheet? 

 

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65. Duration is defined as the weighted average time to maturity of a financial instrument. Explain how this
knowledge can help protect against interest rate risk. 
 

 
66. The futures markets are labeled as pure speculation and even gambling. Why is this an inaccurate portrayal
of the market's function? 
 

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 Chapter 25 Derivatives and Hedging Risk Answer Key

Multiple Choice Questions

 

1. A derivative is a financial instrument whose value is determined by: 

 

A.  a regulatory body such as the FTC.

B.  a primitive or underlying asset.
C.  hedging a risk.
D.  hedging a speculation.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Derivatives, Hedging, and Risk
 
2. Derivatives can be used to either hedge or speculate. These actions: 
 

A.  increase risk in both cases.

B.  decrease risk in both cases.
C.  spread or minimize risk in both cases.
D.  offset risk by hedging and increase risk by speculating.
E.  offset risks by speculating and increase risk by hedging.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Derivatives, Hedging, and Risk
 
3. A forward contract is described by: 
 

A.  agreeing today to buy a product at a later date at a price to be set in the future.
B.  agreeing today to buy a product today at its current price.
C.  agreeing today to buy a product at a later date at a price set today.
D.  agreeing today to buy a product if and only if its price rises above the exercise price today at its
current price.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Forward Contracts
 

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4. The buyer of a forward contract: 
 

A.  will be taking delivery of the good(s) today at today's price.

B.  will be making delivery of the good(s) at a later date at that date's price.
C.  will be making delivery of the good(s) today at today's price.
D.  will be taking delivery of the good(s) at a later date at pre-specified price.
E.  Both will be taking delivery of the good(s) today at today's price or will be taking delivery of the
good(s) at a later date at pre-specified price.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Forward Contracts
 
5. The main difference between a forward contract and a cash transaction is: 
 

A.  only the cash transaction creates an obligation to perform.

B.  a forward is performed at a later date while the cash transaction is performed immediately.
C.  only one involves a deliverable instrument.
D.  neither allows for hedging.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Forward Contracts
 
6. Futures contracts contrast with forward contracts by: 
 

A.  trading on an organized exchange.

B.  marking to the market on a daily basis.
C.  allowing the seller to deliver any day over the delivery month.
D.  All of these.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Futures Contracts
 
7. Which of the following is true about the user of derivatives? 
 

A.  Derivatives usually appear explicitly in the financial statements.

B.  Academic surveys account for much of our knowledge of corporate derivatives use.
C.  Smaller firms are more likely to use derivatives than large firms.
D.  The most frequently used derivatives are commodity and equity futures.
E.  None of these are true.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 3 Hard
Topic: Actual Use of Derivatives
 

25-17
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
8. Which of the following terms is not part of a forward contract? 
 

A.  Making delivery

B.  Taking delivery
C.  Delivery instrument
D.  Cash transaction
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Forward Contracts
 
9. Duration is a measure of the: 
 

A.  yield to maturity of a bond.

B.  coupon yield of a bond.
C.  price of a bond.
D.  effective maturity of a bond.
E.  All of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Duration Hedging
 
10. A swap is an arrangement for two counterparties to: 
 

A.  exchange cash flows over time.

B.  permit fluctuation in interest rates.
C.  help exchange markets clear.
D.  All of these.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Swaps Contracts
 
11. LIBOR stands for: 
 

A.  Lausanne Interest Basis Offered Rate.

B.  London International Offered Rate.
C.  London Interbank Offered Rate.
D.  London Interagency Offered Rate.
E.  None of these.
 
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Swaps Contracts
 

25-18
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
12. A futures contract on gold states that buyers and sellers agree to make or take delivery of an ounce of
gold for $400 per ounce. The contract expires in 3 months. The current price of gold is $400 per ounce.
If the price of gold rises and continues to rise every day over the 3 month period, then when the contract
is settled, the buyer will _____ and the seller will _____. 
 

A.  lose; gain

B.  gain; lose
C.  gain; break even
D.  gain; gain
E.  lose; lose
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Futures Contracts
 
13. A potential disadvantage of forward contracts versus futures contracts is: 
 

A.  the extra liquidity required to cover the potential outflows that occur prior to delivery and caused by
marking to market.
B.  the incentive for a particular party to default.
C.  that the buyers and sellers don't know each other and never meet.
D.  All of these.
E.  Both the extra liquidity required to cover the potential outflows that occur prior to delivery and
caused by marking to market; and that the buyers and sellers don't know each other and never meet.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Forward Contracts
 
14. A farmer with wheat in the fields and who uses the futures market to protect a profit is an example of: 
 

A.  a long hedge.

B.  a short hedge.
C.  selling futures to guard against a potential loss.
D.  Both a long hedge and selling futures to guard against a potential loss.
E.  Both a short hedge and selling futures to guard against a potential loss.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Futures Contracts
 
15. A miller who needs wheat to mill to flour uses the futures market to protect a profit by: 
 

A.  a long hedge to take delivery.

B.  a short hedge to deliver.
C.  buying futures to guard against a potential loss.
D.  Both a long hedge to take delivery; and buying futures to guard against a potential loss.
E.  Both a short hedge to deliver; and buying futures to guard against a potential loss.
 
AACSB: Analytic

25-19
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Blooms: Understand
Difficulty level: 2 Medium
Topic: Futures Contracts
 
16. A chocolate company which uses the futures market to lock in the price of cocoa to protect a profit is an
example of: 
 

A.  a long hedge.

B.  a short hedge.
C.  purchasing futures to guard against a potential loss.
D.  Both a long hedge; and purchasing futures to guard against a potential loss.
E.  Both a short hedge; and purchasing futures to guard against a potential loss.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Futures Contracts
 
17. If the producer of a product has entered into a fixed price sale agreement for that output, the producer
faces: 
 

A.  a nice steady profit because the output price is fixed.

B.  an uncertain profit if the input prices are volatile. This risk can be reduced by a short hedge.
C.  an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
D.  a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
E.  a modest profit if the input prices are stable. This risk can be reduced by a short hedge.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Hedging
 
18. You hold a forward contract to take delivery of U.S. Treasury bonds in 9 months. If the entire term
structure of interest rates shifts down over the 9-month period, the value of the forward contract will
have _____ on the date of delivery. 
 

A.  risen
B.  fallen
C.  not changed
D.  either risen or fallen, depending on the maturity of the T-bond
E.  collapsed
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Forward Contracts
 

25-20
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
19. Two key features of futures contracts that make them more in demand than forward contracts are: 
 

A.  futures are traded on exchanges and must be marked to the market.
B.  futures contracts allow flexibility in delivery dates and provide a liquid market for netting positions.
C.  futures are marked to the market and allow delivery flexibility.
D.  futures are traded in liquid markets and are marked to the market.
E.  All of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Futures Contracts
 
20. If rates in the market fall between now and one month from now, the mortgage banker: 
 

A.  loses as the mortgages are sold at a discount.

B.  gains as the mortgages are sold at a discount.
C.  loses as the mortgages are sold at a premium.
D.  gains as the mortgages are sold at a premium.
E.  neither gains nor loses.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Interest Rate Futures Contracts
 
21. To protect against interest rate risk, the mortgage banker should: 
 

A.  buy futures, as this position will hedge losses if rates rise.
B.  sell futures, as this position will hedge losses if rates rise.
C.  sell futures, as this position will add to his gains if rates rise.
D.  buy futures, as this position will add to his gains if rates rise.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Interest Rate Futures Contracts
 
22. Futures market transactions are used to reduce risk. Risk may not be totally offset if: 
 

A.  the two instruments have different maturities.

B.  payoff schedules of the two instruments are different.
C.  the volatility of the two instruments are different.
D.  the price movements are not perfectly correlated.
E.  All of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Interest Rate Futures Contracts
 

25-21
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
23. Hedging in the futures markets can reduce all risk if: 
 

A.  price movements in both the cash and futures markets are perfectly correlated.
B.  price movements in both the cash and futures markets have zero correlation.
C.  price movements in both the cash and futures markets are less than perfectly correlated.
D.  the hedge is a short hedge, but not a long hedge.
E.  the hedge is a long hedge, but not a short hedge.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Hedging
 
24. Comparing long-term bonds with short-term bonds, long-term bonds are _____ volatile and therefore
experience _____ price change than short-term bonds for the same interest rate shift. 
 

A.  less; less

B.  less; more
C.  more; more
D.  more; less
E.  more; the same
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
25. When interest rates shift, the price of zero coupon bonds: 
 

A.  are more volatile as compared with short-term bonds of the same maturity.
B.  are less volatile as compared with short-term bonds of the same maturity.
C.  are more volatile as compared with long-term bonds of the same maturity.
D.  are less volatile as compared with long-term bonds of the same maturity.
E.  Both are more volatile as compared with short-term bonds of the same maturity; and are more
volatile as compared with long-term bonds of the same maturity.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
26. Duration of a pure discount bond: 
 

A.  is equal to its half-life.

B.  is less than a zero coupon bond.
C.  is equal to the liabilities hedged.
D.  is equal to its maturity.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Duration Hedging

25-22
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
  
27. In percentage terms, higher coupon bonds experience a _______ price change compared with lower
coupon bonds of the same maturity given a change in yield to maturity. 
 

A.  greater
B.  smaller
C.  similar
D.  smaller or greater
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
28. A bond manager who wishes to hold the bond with the greatest potential volatility would be wise to
hold: 
 

A.  short-term, high-coupon bonds.

B.  long-term, low-coupon bonds.
C.  long-term, zero-coupon bonds.
D.  short-term, zero-coupon bonds.
E.  short-term, low-coupon bonds.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Derivatives, Hedging, and Risk
 
29. The duration of a 15 year zero coupon bond priced at $182.70 is: 
 

A.  2.74 years.

B.  15 years.
C.  17.74 years.
D.  cannot determine without the interest rate.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Duration Hedging
 
30. A set of bonds all have the same maturity. Which one has the least percentage price change for given
shifts in interest rates: 
 

A.  zero coupon bonds.

B.  high coupon bonds.
C.  low coupon bonds.
D.  pure discount bonds.
E.  not enough information to determine.
 
AACSB: Analytic
Blooms: Understand

25-23
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
31. A financial institution can hedge its interest rate risk by: 
 

A.  matching the duration of its assets to the duration of its liabilities.
B.  setting the duration of its assets equal to half that of the duration of its liabilities.
C.  matching the duration of its assets, weighted by the market value of its assets with the duration of its
liabilities, weighted by the market value of its liabilities.
D.  setting the duration of its assets, weighted by the market value of its assets to one half that of the
duration of the liabilities, weighted by the market value of the liabilities.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
32. A pure discount bond pays: 
 

A.  no coupons, therefore its duration is equal to its maturity.

B.  discounted coupons, therefore its duration is greater than its maturity.
C.  level coupons, therefore its duration is equal to its maturity.
D.  declining coupons, therefore its duration is less than its maturity.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Duration Hedging
 
33. Duration of a coupon paying bond is: 
 

A.  equal to its number of payments.

B.  less than a zero coupon bond.
C.  equal to the zero coupon bond.
D.  equal to its maturity.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Duration Hedging
 
34. A financial institution has equity equal to one-tenth of its assets. If its asset duration is currently equal to
its liability duration, then to immunize, the firm needs to: 
 

A.  decrease the duration of its assets.

B.  increase the duration of its assets.
C.  decrease the duration of its liabilities.
D.  do nothing, i.e., keep the duration of its liabilities equal to the duration of its assets.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium

25-24
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Topic: Duration Hedging
 
35. If a financial institution has equated the dollar effects of interest rate risk on its assets with the dollar
effects on its liabilities, it has engaged in: 
 

A.  a long hedge.

B.  a short hedge.
C.  a protected swap.
D.  immunizing interest rate risk.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Duration Hedging
 
36. A savings and loan has extremely long-term assets that are currently matched against extremely short-
term liabilities. For this S&L: 
 

A.  falling interest rates will decrease the value of its equity.
B.  falling interest rates will increase the value of its equity.
C.  rising interest rates will increase the value of its equity.
D.  rising interest rates will decrease the value of its equity.
E.  Both falling interest rates will increase the value of its equity; and rising interest rates will decrease
the value of its equity.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Interest Rate Futures Contracts
 
37. Interest rate and currency swaps allow one party to exchange a: 
 

A.  floating interest rate or currency value for a fixed value over the contract term.
B.  fixed interest rate or currency value for a lower fixed value over the contract term.
C.  floating interest rate or currency value for a lower floating value over the contract term.
D.  fixed interest rate position for a currency position over the contract term.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Swaps Contracts
 
38. Exotic derivatives are complicated blends of other derivatives. Some exotics are: 
 

A.  inverse floaters.

B.  cap and floors.
C.  futures.
D.  Both inverse floaters; and cap and floors.
E.  Both cap and floors; and futures.
 
AACSB: Analytic

25-25
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Blooms: Understand
Difficulty level: 2 Medium
Topic: Swaps Contracts
 
39. An inverse floater and a super-inverse floater are more valuable to a purchaser if: 
 

A.  interest rates stay the same.

B.  interest rates fall.
C.  interest rates rise.
D.  held for a long time.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Swaps Contracts
 
40. If a firm purchases a cap at 10% this will: 
 

A.  limit the amount of borrowing to 10% of assets.

B.  pay the firm 10% on their purchase.
C.  pay the holder the LIBOR interest above 10%.
D.  pay the holder the LIBOR interest below the 10%.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Swaps Contracts
 
41. If a firm sells a floor at 6% this will: 
 

A.  pay the holder the LIBOR interest below the 6%.
B.  pay the firm 6% on their purchase.
C.  pay the holder the LIBOR interest above 6%.
D.  limit the amount of borrowing to 6% of assets.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: Swaps Contracts
 
42. In the practical use of credit default swaps there: 
 

A.  is not an organized exchange or template for the agreement.

B.  is an organized exchange or template for the agreement.
C.  are laws making them illegal in the United States.
D.  are limits to the amount of borrowing of both parties.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium

25-26
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Topic: Swaps Contracts
 
43. Credit default swaps: 
 

A.  will pay the holder the LIBOR interest rate.

B.  pay the borrower the LIBOR interest rate.
C.  are like insurance against a loss of value if the firm defaults on a bond.
D.  limit the amount of borrowing of all parties in the credit default swap.
E.  None of these.
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Swaps Contracts
 
44. There are always ___ counterparties in a credit default swap: 
 

A.  0
B.  1
C.  2
D.  3
E.  more than three
 
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Swaps Contracts
 
45. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the next 5 days
the contract settled at 2.52, 2.57, 2.62, 2.68, and 2.70. You then decide to reverse your position in the
futures market on the fifth day at close. What is the net amount you receive at the end of 5 days? 
 

A.  $0.00
B.  $2.60
C.  $2.70
D.  $2.80
E.  Must know the number of contracts

Contract nets to you the original price. The net position is based on daily marking to the market. The net
change is $- .10, Close - Change = $2.70 -$10 = $2.60

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 

25-27
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
46. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the next 5 days
the contract settled at 2.52, 2.57, 2.62, 2.68, and 2.70. Before you can reverse your position in the futures
market on the fifth day you are notified to complete delivery. What will you receive on delivery and
what is the net amount you receive in total? 
 

A.  $2.60; $-0.10

B.  $2.60; $0.10
C.  $2.60; $2.70
D.  $2.70; $-0.10
E.  $2.70; $2.60

Delivery is made at the settle price of $2.70. The net position is based on daily marking to the market.
The difference of -.10 = (.08 + -.05 + -.05 + -.06 + - .02), which is a loss versus the last settle price.

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
47. You bought a futures contract for $2.60 per bushel and the contract ended at $2.70 after several days of
trading with the following close prices each day: $2.52, $2.57, $2.62, $2.68, and $2.70. What would the
mark to market sequence be? 
 

A.  -.08, .05, .05, .06, .02

B.  .08, -.05, -.05, -.06, -.02
C.  .08, .03, -.02, -.06, -.10
D.  -.08, -.03, .02, .06, .10
E.  .10, .06, .02, -.03, -.08

Daily marking to the market from prior day settle.

($2.52 - $2.60; $2.57 - $2.52; $2.62 - $2.57; $2.68 - $2.62; $2.70 - $2.68) = ($-.08; $.05; $.05; $.06;
$.02)

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 

25-28
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
48. Suppose you agree to purchase one ounce of gold for $382 any time over the next month. The current
price of gold is $380. The spot price of gold then falls to $377 the next day. If the agreement is
represented by a futures contract marking to market on a daily basis as the price changes, what is your
cash flow at the end of the next business day? 
 

A.  $0
B.  $3
C.  $5
D.  -$3
E.  -$5

Δ Futures Position = Δ Spot = $377 - $380 = $-3

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
49. On March 1, you contract to take delivery of 1 ounce of gold for $415. The agreement is good for any
day up to April 1. Throughout March, the price of gold hit a low of $385 and hit a high of $435. The
price settled on March 31 at $420, and on April 1st you settle your futures agreement at that price. Your
net cash flow is: 
 

A.  -$30.
B.  -$20.
C.  -$15.
D.  $5.
E.  $20.

NCF = $420 - $415 = $5

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
50. A bank has a $50 million mortgage bond risk position which it hedges in the Treasury bond futures
markets at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the
hedge? 
 

A.  5
B.  50
C.  500
D.  5,000
E.  50,000

Portfolio Value/TB and Contract Value = $50,000,000/$100,000 = 500

 
AACSB: Analytic

25-29
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Blooms: Apply
Difficulty level: 1 Easy
Topic: Futures Contracts
 
51. A mortgage banker had made loan commitments for $10 million in 3 months. How many contracts on
Treasury bonds futures must the banker write or buy? 
 

A.  Go short 10.

B.  Go short 100.
C.  Go long 10.
D.  Go long 100.
E.  None of these.

Must write/go short = $10,000,000/$100,000 = 100

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
52. The duration of a 2 year annual 10% bond that is selling for par is: 
 

A.  1.00 years.

B.  1.91 years.
C.  2.00 years.
D.  2.09 years.
E.  None of these.

D = 1[(100/1.1)]/1000 + 2[(1100/1.12)]/1000 = .09091 + 1.81818 = 1.90909 = 1.91 years

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Duration Hedging
 
53. Firm A is paying $750,000 in interest payments a year while Firm B is paying LIBOR plus 75 basis
points on $10,000,000 loans. The current LIBOR rate is 6.5%. Firm A and B have agreed to swap
interest payments. What is the net payment this year? 
 

A.  Firm A pays $750,000 to Firm B

B.  Firm B pays $725,000 to Firm A
C.  Firm B pays $25,000 to Firm A
D.  Firm A pays $25,000 to Firm B
E.  None of these.

Firm A pays a fixed payment of $750,000 to B in exchange for the floating payment of (.065 + .0075)
10,000,000 = 725,000. The net position is that Firm A pays $25,000 to Firm B.

 
AACSB: Analytic
Blooms: Apply

25-30
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Difficulty level: 2 Medium
Topic: Swaps Contracts
 
54. A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent annual coupon
rate. The $1,000 face value is returned at maturity. If the effective annual yield for all maturities is 7
percent annually, what is the current price of the Treasury note? 
 

A.  $960.68
B.  $986.69
C.  $1,010.35
D.  $1,034.40
E.  $1,038.99

The semi-annual spot rates are (1.07.5) = 1.0344

P = 45 A4,3.44+ 10454,3.44PV = $1,038.99

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
55. Calculate the duration of a 7-year $1,000 zero-coupon bond with a current price of $399.63 and a yield
to maturity of 14%. 
 

A.  5 years
B.  6 years
C.  7 years
D.  8 years
E.  9 years

Duration of a zero is always equal to its maturity = 7 years.

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Duration Hedging
 
56. Calculate the duration of a 4-year $1,000 face value bond, which pays 8% coupons annually throughout
maturity and has a yield to maturity of 9%. 
 

A.  3.29 years

B.  3.57 years
C.  3.69 years
D.  3.89 years
E.  4.00 years

D = [80/(1.09 + 160)/(1.09)2+ 240/(1.09)3+ 4,320/(1.09)4]/967.60 = 3453.78/967.60 = 3.57 years.

 
AACSB: Analytic
Blooms: Apply

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Difficulty level: 2 Medium
Topic: Duration Hedging
 
57. On March 1, you contract to take delivery of 1 ounce of gold for $495. The agreement is good for any
day up to April 1. Throughout March, the price of gold hit a low of $425 and hit a high of $535. The
price settled on March 31 at $505, and on April 1st you settle your futures agreement at that price. Your
net cash flow is: 
 

A.  -$30.
B.  -$20.
C.  -$15.
D.  $10.
E.  $20.

NCF = $505 - $495 = $10

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
58. A bank has a $80 million mortgage bond risk position which it hedges in the Treasury bond futures
markets at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the
hedge? 
 

A.  8
B.  80
C.  800
D.  8,000
E.  80,000

Portfolio Value/TB and Contract Value = $80,000,000/$100,000 = 800

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Futures Contracts
 

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
59. Suppose you agree to purchase one ounce of gold for $984 any time over the next month. The current
price of gold is $970. The spot price of gold then falls to $960 the next day. If the agreement is
represented by a futures contract marking to market on a daily basis as the price changes, what is your
cash flow at the end of the next business day? 
 

A.  $10
B.  $5
C.  $0
D.  -$5
E.  -$10

Δ Futures Position = Δ Spot = $960 - $970 = $-10

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
60. On June 1, you contract to take delivery of 1 ounce of gold for $965. The agreement is good for any day
up to July 1. Throughout June, the price of gold hit a low of $960 and hit a high of $990. The price
settled on June 30 at $980, and on July 1st you settle your futures agreement at that price. Your net cash
flow is: 
 

A.  -$20.
B.  -$15.
C.  -$5
D.  $15.
E.  $20.

NCF = $980 - $965 = $15

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
61. A bank has a $100 million mortgage bond risk position which it hedges in the Treasury bond futures
markets at the Chicago Board of Trade. Approximately how many contracts are needed to be held in the
hedge? 
 

A.  10
B.  100
C.  1,000
D.  10,000
E.  100,000

Portfolio Value/TB and Contract Value = $100,000,000/$100,000 = 1,000

 
AACSB: Analytic

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 Blooms: Apply
Difficulty level: 1 Easy
Topic: Futures Contracts
 
62. A mortgage banker had made loan commitments for $20 million in 3 months. How many contracts on
Treasury bonds futures must the banker write or buy? 
 

A.  Go short 20.

B.  Go short 200.
C.  Go long 20.
D.  Go long 200.
E.  None of these.

Must write/go short = $20,000,000/$100,000 = 200

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Futures Contracts
 
 

Essay Questions
 

63.

   

Calculate the duration of Tiger State Bank's assets and liabilities. 

 

DA = (3/39)(0) + (8/39)(.6) + (20/39)(2.2) + (8/39)(7.5) = 2.79 years

DL = (20/36)(0) + (4/36)(.4) + (12/36)(3.2) = 1.111 years

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 3 Hard
Topic: Duration Hedging
 

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any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
64.

   

What new asset duration will immunize the balance sheet? 

 

Given DL = 1.111, then DA × 39 = 1.111(36); DA = 1.0255 years

 
AACSB: Analytic
Blooms: Apply
Difficulty level: 3 Hard
Topic: Duration Hedging
 
65. Duration is defined as the weighted average time to maturity of a financial instrument. Explain how this
knowledge can help protect against interest rate risk. 
 

Duration measures effective time to recoup your investment. Bond prices rise and fall with interest rate
changes. There are two elements of risk. The first being reinvestment risk--may earn less money when
reinvesting, and the second being price. The value of the bond moves inversely with interest rates. By
setting duration equal to holding horizon, reinvestment and price risk offset each other. By setting
duration of assets equal to duration of liabilities, both move up and down together.

 
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 3 Hard
Topic: Duration Hedging
 

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66. The futures markets are labeled as pure speculation and even gambling. Why is this an inaccurate
portrayal of the market's function? 
 

There are several reasons:

The market sets (discovers) prices for assets;

Future positions are for performance at a later date, not a spot transaction;
Earnest money as margin based on performance;
Speculators bear risk for hedgers; and
Hedgers are spreading/reducing their risk.
Therefore, the market is zero-sum game and positions can be netted easily and marking to market takes
place daily.

 
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: Futures Contracts
 

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