1.

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.
Answer: A

2. 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.
Answer: D

3. 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.
Answer: A

4. An interest-rate swap involves the exchange of one set of interest payments for
another set of interest payments, and typically specifies all of the following, except
A) the interest rate on the payments that are being exchanged
B) the type of interest payments
C) the strike, or exercise, price
D) the notional principal
Answer: C

5. 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.
Answer: B

6. 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
Answer: A
 7. 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.
Answer: B

8. 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.
Answer: D

9. The seller of an option has the ________ to buy or sell the underlying asset, while the
purchaser of an option has the ________ to buy or sell the asset.
A) obligation; right
B) right; obligation
C) obligation; obligation
D) right; right
Answer: A

10. If a firm is due to be paid in euros in two months, to hedge against exchange rate risk
the firm should
A) sell foreign exchange futures short.
B) buy foreign exchange futures long.
C) stay out of the exchange futures market.
D) do none of the above.
Answer: A

True/False

11. A long contract obligates the holder to sell securities in the future.
Answer: FALSE

12. A short contract obligates the holder to sell securities in the future.
Answer: TRUE

13. A forward contract is more flexible than a futures contract.

Answer: TRUE

14. Hedging risk involves engaging in a financial transaction that offsets a long position
by taking an additional long position.
Answer: FALSE

15. Futures contracts are standardized.

Answer: TRUE
16. Leticia has to hedge the interest rate risk of her holdings of $6,480,000 in Treasury bonds by
buying or selling futures contracts. Determine the type of transaction and the price of each
contract if Leticia buys/sells 48 contracts.
Solution: To offset the long position Leticia has to take a short position by selling futures
contracts for the amount to hedge. If Leticia sold 48 futures contract, then each contract sells
for $6,480,000/48 = $135,000.
17. Suppose you buy a call option on a $100,000 Treasury bond futures contract with an exercise
price of 105. If the price of the Treasury bond is 115 at expiration, is the option at the money,
in the money or out of the money? Determine the premium if the profit equals $8,000.

Solution: The call option is “in the money” because you would want to exercise the right to buy
the Treasury bonds at $105 and then sell them at $115, for a profit. If the profit equaled $8,000
this means that the premium was (115 – 105) × 100,000 – 8,000 = $2,000.

18. A bank issues a $100,000 variable-rate, 30-year mortgage with a nominal annual rate of 4.5%.
If the required rate drops to 4.0% after the first six months, what is the impact on the interest
income for the first 12 months? Assume the bank hedged this risk with a short position in a
181-day T-bill future. The original price was and the final price was on a
$100,000 face value contract.
Did this work?
Solution: At 4.5%, the required payment is calculated as:
PV  100,000, I  4.5/12, N  360, FV  0
Compute PMT. PMT  506.685
If rate remain at 4.5%, the mortgage balance after 12 months is:
PMT  506.685, N  348, I  4.5/12, FV  0
Compute PV. PV  $98,386.71, or $1,613.29 of the payments went toward principal.
The total payments  $506.685 ´ 12  $6,080.22.
Interest income for the year is $6080.22  $1613.29  $4,466.93
If rates drop to 4% for the last 6 months of the year:
First, calculate the interest for the first six months:
PMT  506.685, N  354, I  4.5/12, FV  0
Compute PV. PV = $99,202.38, or $797.62 of the payments went toward principal.
The total payments = $506.685 × 6 = $3,040.11.
 Interest income for the year is $3040.11  $797.62  $2,242.49
Next, calculate the interest for the last six months:
At 4.0%, the required payment is calculated as:
PV  99,202.38, I  4.0/12, N  354, FV  0
Compute PMT. PMT  477.772
PMT  477.772, N  348, I  4.0/12, N  354, FV  0
Compute PV. PV  $98,312.41, or $889.97 of the payments went toward principal.
The total payments  $477.772 ´ 6  $2,866.63.
Interest income for the year is $2866.63  $889.97  $1,976.66
Total interest income  $2,242.49  $1,976.66  $4,219.15
Interest income has fallen by $247.78, or 5.5%.
The gain on the T-bill future  (98 1/32  97 26/32) ´ 1,000  218.75. This reduced
the loss in interest income to just $29!
19. Laura, a bond portfolio manager, administers a $10 million portfolio. The portfolio currently
has
a duration of 8.5 years. Laura wants to shorten the duration to 6 years using T-bill futures. T-
bill futures have a duration of 0.25 years and are trading at $975 (face value  $1,000). How
is this accomplished?
Solution: The average portfolio duration needs to be 6 years.
10,000,000 ´ 6  (10,000,000 ´ 8.5)  (Y ´ 0.25)
60,000,000  85,000,000  (Y ´ 0.25)
25,000,000  Y ´ 0.25
Y  $100,000,000
Laura must take a short position in $100,000,000 worth of T-bill futures. At the
current price, this requires 100,000,000/975  102,564 contracts.
20. Suppose you buy a futures contract at a price of 107 and that the margin requirement is 2
points. Determine the settlement price at which you will receive a margin call if the
maintenance margin requirement is 1 point.
Solution: Since each point equals $1,000 of the contract, the settlement price at which you will
receive a margin call satisfies the following equation:
1,000 = 2,000 ‒ (107 ‒ SP) × 1,000 → SP = 106
Therefore if the price drops to 106, your balance at the brokerage firm drops to $1,000, your
maintenance margin requirement.
21. Chicago Bank and Trust has $100 million in assets and $83 million in liabilities. The duration
of the assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures
contracts does this bank need to fully hedge itself against interest rate risk? The available
Treasury bond futures contracts have a duration of 10 years, a face value of $1,000,000, and
are selling for $979,000.
 Solution: This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the
duration of the liabilities, so the bank will take a short position, effectively increasing
its liabilities. Assume that the dollar amount of the position is Y.

83*1.8 + X *10 = 5.9 * 100; X=44,060,000 44,060,000/979,000= 45

22. A bank issues a $3 million commercial mortgage with a nominal APR of 8%. The loan is
fully amortized over 10 years requiring monthly payments. The bank plans on selling the loan
after
2 months. If the required nominal APR increases by 45 basis points when the loan is sold,
what
loss does the bank incur?
Solution: The mortgage requires monthly payments as follows:
PV = 3000000, I = 8/12, N = 120, FV = 0
Compute PMT. PMT = $36,398.28
After 2 months, the remaining balance is:
PMT = 36398.28, I = 8/12, N = 118, FV = 0
Compute PV. PV = $2,967,094.27
However, at the prevailing rate, the mortgage is sold for:
PMT = 36398.28, I = 8.45/12, N = 118, FV = 0
Compute PV. PV = $2,910,552.12, or at a loss of $56,542.15
23. Assume the bank in the previous question partially hedges the mortgage by selling three 10-
year
T-note futures contracts at a price of Each contract is for $1,000,000. After 2
months, the futures contract has fallen in price to What was the gain or loss on the
futures transaction?
Solution: On each contract, the gain is

Total gain = $18,750 ´ 3 = $56,250

24. Springer Country Bank has assets totaling $180 million with a duration of 5 years, and
liabilities totaling $160 million with a duration of 2 years. Bank management expects interest
rates to fall from 9% to 8.25% shortly. A T-bond futures contract is available for hedging. Its
duration is 6.5 years and is currently priced at How many contracts does Springer
need to hedge against the expected rate change? Assume each contract is has a face value of
$1,000,000.
Solution: $180 million ´ 5 = ($160 million ´ 2) + (TB ´ 6.5)
TB = 89,230,769
Since the current price is $991,562.50, this requires 90 contracts. They should take a
short position.