(Test Bank) Hull: Options, Futures, and Other Derivatives

Hull, 9

Business

Test Bank

9th Edition

• $10.00 $35.00

---

Description

Test Bank for Hull: Options, Futures, and Other Derivatives, The downloadable file consists of 162 pages, and the total size of the file is 2.73 MB. Purchase now only for highly discounted price.

Author(s): Hull

---

---

Study Note Preview

Hull: Options, Futures, and Other Derivatives, Ninth Edition, Global Edition Chapter 1: Introduction Multiple Choice Test Bank: Questions with Answers 1. A one-year forward contract is an agreement where A. One side has the right to buy an asset for a certain price in one year’s time. B. One side has the obligation to buy an asset for a certain price in one year’s time. C. One side has the obligation to buy an asset for a certain price at some time during the next year. D. One side has the obligation to buy an asset for the market price in one year’s time. Answer: B A one-year forward contract is an obligation to buy or sell in one year’s time for a predetermined price. By contrast, an option is the right to buy or sell. 2. Which of the following is NOT true A. When a CBOE call option on IBM is exercised, IBM issues more stock B. An American option can be exercised at any time during its life C. An call option will always be exercised at maturity if the underlying asset price is greater than the strike price D. A put option will always be exercised at maturity if the strike price is greater than the underlying asset price. Answer: A When an IBM call option is exercised the option seller must buy shares in the market to sell to the option buyer. IBM is not involved in any way. Answers B, C, and D are true. 3. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call options and one put option. The breakeven stock price above which the trader makes a profit is A. $35 B. $40 C. $30 D. $36 Answer: A When the stock price is $35, the two call options provide a payoff of 2×(35−30) or $10. The put option provides no payoff. The total cost of the options is 2×3+ 4 or $10. The stock price in A, $35, is therefore the breakeven stock price above which the position is profitable because it is the price for which the cost of the options equals the payoff. 4. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call options and one put option. The breakeven stock price below which the trader makes a profit is A. $25 B. $28 C. $26 D. $20 Answer: D When the stock price is $20 the two call options provide no payoff. The put option provides a payoff of 30−20 or $10. The total cost of the options is 2×3+ 4 or $10. The stock price in D, $20, is therefore the breakeven stock price below which the position is profitable because it is the price for which the cost of the options equals the payoff. 5. Which of the following is approximately true when size is measured in terms of the underlying principal amounts or value of the underlying assets A. The exchange -traded market is twice as big as the over -the-counter market. B. The over -the-counter market is twice as big as the exchange -traded market. C. The exchange -traded market is ten times as big as the over -the-counter market. D. The over -the-counter market is ten times as big as the exchange -traded market. Answer: D The OTC market is about $600 trillion whereas the exchange -traded market is about $60 trillion. 6. Which of the following best describes the term “spot price” A. The price for immediate delivery B. The price for delivery at a future time C. The price of an asset that has been damaged D. The price of renting an asset Answer: A The spot price is the price for immediate delivery. The futures or forward price is the price for delivery in the future 7. Which of the following is true about a long forward contract A. The contract becomes more valuable as the price of the asset declines B. The contract becomes more valuable as the price of the asset rises C. The contract is worth zero if the price of the asset declines after the contract has been entered into D. The contract is worth zero if the price of the asset rises after the contract has been entered into Answer: B A long forward contract is an agreement to buy the asset at a predetermined price. The contract becomes more attractive as the market price of the asset rises. The contract is only worth zero when the predetermined price in the forward contract equals the current forward price (as it usually does at the beginning of the contract). 8. An investor sells a futures contract an asset when the futures price is $1,500. Each contract is on 100 units of the asset. The contract is closed out when the futures price is $1,540. Which of the following is true A. The inve stor has made a gain of $4,000 B. The investor has made a loss of $4,000 C. The investor has made a gain of $2,000 D. The investor has made a loss of $2,000 Answer: B An investor who buys (has a long position) has a gain when a futures price increases. An investor who sells (has a short position) has a loss when a futures price increases. 9. Which of the following describes European options? A. Sold in Europe B. Priced in Euros C. Exercisable only at maturity D. Calls (there are no European puts) Answer: C European options can be exercised only at maturity. This is in contrast to American options which can be exercised at any time. The term “European” has nothing to do with geographical location, currencies, or whether the option is a call or a put. 10. Which of the following is NOT true A. A call option gives the holder the right to buy an asset by a certain date for a certain price B. A put option gives the holder the right to sell an asset by a certain date for a certain price C. The holder of a call or put option must exercise the right to sell or buy an asset D. The holder of a forward contract is obligated to buy or sell an asset Answer: C The holder of a call or put option has the right to exercise the option but is not required to do so. A, B, and C are correct 11. Which of the following is NOT true about call and put options: A. An American option can be exercised at any time during its life B. A European option can only be exercised only on the maturity date C. Investors must pay an upfront price (the option premium) for an option contract D. The price of a call option increases as the strike price increases Answer: D A call option is the option to buy for the strike price. As the strike price increases this option becomes less attractive and is therefore less valuable. A, B, and C are true. 12. The price of a stock on July 1 is $57. A trader buys 100 call options on the stock with a strike price of $60 when the option price is $2. The options are exercised when the stock price is $65. The trader’s net profit is A. $700 B. $500 C. $300 D. $600 Answer: C The payoff from the options is 100×(65 -60) or $500. The cost of the options is 2×100 or $200. The net profit is therefore 500−200 or $300. 13. The price of a stock on February 1 is $124. A trader sells 200 put options on the stock with a strike price of $120 when the option price is $5. The options are exercised when the stock price is $110. The trader’s net profit or loss is A. Gain of $1,000 B. Loss of $2,000 C. Loss of $2,800 D. Loss of $1,000 Answer: D The payoff that must be made on the options is 200×(120−110) or $2000. The amount received for the options is 5×200 or $1000. The net loss is therefore 2000−1000 or $1000. 14. The price of a stock on February 1 is $84. A trader buys 200 put options on the stock with a strike price of $90 when the option price is $10. The options are exercised when the stock price is $85. The trader’s net profit or loss is A. Loss of $1,000 B. Loss of $2,000 C. Gain of $200 D. Gain of $1000 Answer: A The payoff is 90−85 or $5 per option. For 200 options the payoff is therefore 5×200 or $1000. However the options cost 10×200 or $2000. There is therefore a net loss of $1000. 15. The price of a stock on February 1 is $48. A trader sells 200 put options on the stock with a strike price of $40 when the option price is $2. The options are exercised when the stock price is $39. The trader’s net profit or loss is A. Loss of $800 B. Loss of $200 C. Gain of $200 D. Loss of $900 Answer: C The payoff is 40−39 or $1 per option. For 200 options the payoff is therefore 1×200 or $200. However the premium received by the trader is 2×200 or $400. The trader therefore has a net gain of $200. 16. A speculator can choose between buying 100 shares of a stock for $40 per share and buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For second alternative to give a better outcome at the option maturity, the stock price must be above A. $45 B. $46 C. $55 D. $50 Answer: D When the stock price is $50 the first alternative leads to a position in the stock worth 100×50 or $5000. The second alternative leads to a payoff from the options of 1000×(50−45) or $5000. Both alternatives cost $4000. It follows that the alternatives are equally profitable when the stock price is $50. For stock prices above $50 the option alternative is more profitable. 17. A company knows it will have to pay a certain amount of a foreign currency to one of its suppliers in the future. Which of the following is true A. A forward contract can be used to lock in the exchange rate B. A forward contract will always give a better outcome than an option C. An option will always give a better outcome than a forward contract D. An option can be used to lock in the exchange rate Answer: A A forward contract ensures that the effective exchange rate will equal the current forward exchange rate. An option provides insurance that the exchange rate will not be worse than a certain level, but requires an upfront premium. Options sometimes give a better outcome and sometimes give a worse outcome than forwards. 18. A short forward contract on an asset plus a long position in a European call option on the asset with a strike price equal to the forward price is equivalent to A. A short position in a call option B. A short position in a put option C. A long position in a put option D. None of the above Answer: C Suppose that S T is the final asset price and K is the strike price/forward price. A short forward contract leads to a payoff of K−S T. A long position in a European call option leads to a payoff of max(S T−K, 0). When added together we see that the total position leads to a payoff of max(0, K−S T), which is the payoff from a long position in a put option. C can also be seen to be true by plotting the payoffs as a function of the final stock price. 19. A trader has a portfolio worth $5 million that mirrors the performance of a stock index. The stock index is currently 1,250. Futures contracts trade on the index with one contract being on 250 times the index. To remove market risk from the portfolio the trader should A. Buy 16 contracts B. Sell 16 contracts C. Buy 20 contracts D. Sell 20 contracts Answer: B One futures contract protects a portfolio worth 1250×250. The number of contract required is therefore 5,000,000/(1250×250)=16. To remove market risk we need to gain on the contracts when the market declines. A short futures position is therefore required. 20. Which of the following best describes a central clearing party A. It is a trader that works for an exchange B. It stands between two parties in the over -the-counter market C. It is a trader that works for a bank D. It helps facilitate futures trades Answer: B A central clearing party (CCP) is a clearing house that stands between two parties in the over - the-counter market. It serves the same purpose as an exchange clearing house. Hull: Options, Futures, and Other Derivatives, Ninth Edition, Global Edition Chapter 2: Mechanics of Futures Markets Multiple Choice Test Bank: Question with Answers 1. Which of the following is true A. Both forward and futures contracts are traded on exchanges. B. Forward contracts are traded on exchanges, but futures contracts are not. C. Futures contracts are traded on exchanges, but forward contracts are not. D. Neither futures contracts nor forward contracts are traded on exchanges. Answer: C Futures contracts trade only on exchanges. Forward contracts trade only in the over -the-counter market. 2. Which of the following is NOT true A. Futures contracts nearly always last longer than forward contracts B. Futures contracts are standardized; forward contracts are not. C. Delivery or final cash settlement usually takes place with forward contracts; the same is not true of futures contracts. D. Forward contracts usually have one specified delivery date; futures contract often have a range of delivery dates. Answer: A Forward contracts often last longer than futures contracts. B, C, and D are true 3. In the corn futures contract a number of different types of corn can be delivered (with price adjustments specified by the exchange) and there are a number of different delivery locations. Which of the following is true A. This flexibility tends increase the futures price. B. This flexibility tends decrease the futures price. C. This flexibility may increase and may decrease the futures price. D. This flexibility has no effect on the futures price Answer: B The party with the short position chooses between the alternatives. The alternatives therefore make the futures contract more attractive to the party with the short position. The lower the futures price the less attractive it is to the party with the short position. The benefit of the alternatives available to the party with the short position is therefore compensated for by the futures price bein g lower than it would otherwise be. 4. A company enters into a short futures contract to sell 50,000 units of a commodity for 70 cents per unit. The initial margin is $4,000 and the maintenance margin is $3,000. What is the futures price per unit above which there will be a margin call? A. 78 cents B. 76 cents C. 74 cents D. 72 cents Answer: D There will be a margin call when more than $1000 has been lost from the margin account so that the balance in the account is below the maintenance margin level. Because the company is short, each one cent rise in the price leads to a loss or 0.01×50,000 or $500. A greater than 2 cent rise in the futures price will therefore lead to a margin call. The futures price is currently 70 cents. When the price rises above 72 cents there will be a margin call. 5. A company enters into a long futures contract to buy 1,000 units of a commodity for $60 per unit. The initial margin is $6,000 and the maintenance margin is $4,000. What futures price will allow $2,000 to be withdrawn from the margin account? A. $58 B. $62 C. $64 D. $66 Answer: B Amounts in the margin account in excess of the initial margin can be withdrawn. Each $1 increase in the futures price leads to a gain of $1000. When the futures price increases by $2 the gain will be $2000 and this can be withdrawn. The futures price is currently $60. The answer is therefore $62. 6. One futures contract is traded where both the long and short parties are closing out existing positions. What is the resultant change in the open interest? A. No change B. Decrease by one C. Decrease by two D. Increase by one Answer: B The open interest goes down by one. There is one less long position and one less short position. 7. Who initiates delivery in a corn futures contract A. The party with the long position B. The party with the short position C. Either party D. The exchange Answer: B The party with the short position initiates delivery by sending a “Notice of Intention to Deliver” to the exchange. The exchange has a procedure for choosing a party with a long position to take delivery. 8. You sell one December futures contracts when the futures price is $1,010 per unit. Each contract is on 100 units and the initial margin per contract that you provide is $2,000. The maintenance margin per contract is $1,500. During the next day the futures price rises to $1,012 per unit. What is the balance of your margin account at the end of the day? A. $1,800 B. $3,300 C. $2,200 D. $3,700 Answer: A The price has increased by $2. Because you have a short position you lose 2×100 or $200. The balance in the margin account therefore goes down from $2,000 to $1,800. 9. A hedger takes a long position in a futures contract on a commodity on November 1, 2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31, 2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on March 1, 2013. What gain is recognized in the accounting year January 1 to December 31, 2013? Each contract is on 1000 u nits of the commodity. A. $0 B. $1,000 C. $3,000 D. $4,000 Answer: D Hedge accounting is used. The whole of the gain or loss on the futures is therefore recognized in 2013. None is recognized in 2012. In this case the gain is $4 per unit or $4,000 in total. 10. A speculator takes a long position in a futures contract on a commodity on November 1, 2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31, 2012 the futures price is $61. On March 1, 2013 it is $64. The con tract is closed out on March 1, 2013. What gain is recognized in the accounting year January 1 to December 31, 2013? Each contract is on 1000 units of the commodity. A. $0 B. $1,000 C. $3,000 D. $4,000 Answer: C In this case there is no hedge accounting. Gains or losses are accounted for as they are accrued. The price per unit increases by $3 in 2013. The total gain in 2013 is therefore $3,000. 11. The frequency with which futures margin accounts are adjusted for gains and losses is A. Daily B. Weekly C. Monthly D. Quarterly Answer: A In futures contracts margin accounts are adjusted for gains or losses daily. 2. Margin accounts have the effect of A. Reducing the risk of one party regretting the deal and backing out B. Ensuring funds are available to pay traders when they make a profit C. Reducing systemic risk due to collapse of futures markets D. All of the above Answer: D Initial margin requirements dramatically reduce the risk that a party will walk away from a futures contract. As a result they reduce the risk that the exchange clearing house will not have enough funds to pays profits to traders. Furthermore, if traders are less likely to suffer losses because of counterparty defaults there is less systemic risk. 3. Which entity in the United States takes primary responsibility for regulating futures market? A. Federal Reserve Board B. Commodities Futures Trading Commission (CFTC) C. Security and Exchange Commission (SEC) D. US Treasury Answer: B The CFTC has primary responsibility for regulating futures markets 4. For a futures contract trading in April 2012, the open interest for a June 2012 contract, when compared to the open interest for Sept 2012 contracts, is usually A. Higher B. Lower C. The same D. Equally likely to be higher or lower Answer: A The contracts which are close to maturity tend to have the highest open interest. However, during the maturity month itself the open interest declines. 5. Clearing houses are A. Never used in futures markets and sometimes used in OTC markets B. Used in OTC markets, but not in futures markets C. Always used in futures markets and sometimes used in OTC markets D. Always used in both futures markets and OTC markets Answer: C Clearing houses are always used by exchanges trading futures. Increasingly, OTC products are cleared through CCPs, which are a type of clearing house. 6. A haircut of 20% means that A. A bond with a market value of $100 is considered to be worth $80 when used to satisfy a collateral request B. A bond with a face value of $100 is considered to be worth $80 when used to satisfy a collateral request C. A bond with a market value of $100 is considered to be worth $83.3 when used to satisfy a collateral request D. A bond with a face value of $100 is considered to be worth $83.3 when used to satisfy a collateral request Answer: A A haircut is the amount the market price of asset is reduced by for the purposes of determining its value for collateral purposes. A is therefore correct. 7. With bilateral clearing, the number of agreements between four dealers, who trade with each other, is A. 12 B. 1 C. 6 D. 2 Answer: C Suppose the dealers are W, X, Y , and Z. The agreements are between W and X, W and Y, W and Z, X and Y, X and Z, and Y and Z. There are therefore a total of 6 agreements. 8. Which of the following best describes central clearing parties A. Help market participants to value derivative transactions B. Must be used for all OTC derivative transactions C. Are used for futures transactions D. Perform a similar function to exchange clearing houses Answer: D CCPs do for the OTC market what exchange clearing houses do for the exchange -traded market. The correct answer is therefore D. CCPs must be used for most standard OTC derivatives transactions, but not for all derivatives transactions. 9. Which of the following are cash settled A. All futures contract s B. All option contracts C. Futures on commodities D. Futures on stock indices Answer: D Futures on stock indices are usually cash settled. The rest are usually settled by delivery of the underlying assets 10. A limit order A. Is an order to trade up to a certain number of futures contracts at a certain price B. Is an order that can be executed at a specified price or one more favorable to the investor C. Is an order that must be executed within a specified period of time D. None of the above Answer: B In a limit order a trader specifies the worst price (from the trader’s perspective) at which the trade can be carried out. Hull: Options, Futures and Other Derivatives, Ninth Edition, Global Edition Chapter 3: Hedging Strategies Using Futures Multiple Choice Test Bank: Questions with Answers 1. The basis is defined as spot minus futures. A trader is hedging the sale of an asset with a short futures position. The basis increases unexpectedly. Which of the following is true? A. The hedger’s position improves. B. The hedger’s position worsens. C. The hedger’s position sometimes worsens and sometimes improves. D. The hedger’s position stays the same. Answer: A The price received by the trader is the futures price plus the basis. It follows that the trader’s position improves when the basis increases. 2. Futures contracts trade with every month as a delivery month. A company is hedging the purchase of the underlying asset on June 15. Which futures contract should it use? A. The June contract B. The July contract C. The May contract D. The August contract Answer: B As a general rule the futures maturity month should be as close as possible to but after the month when the asset will be purchased. In this case the asset will be purchased in June and so the best contract is the July contract. 3. On March 1 a commodity’s spot price is $60 and its August futures price is $59. On July 1 the spot price is $64 and the August futures price is $63.50. A company entered into futures contracts on March 1 to hedge its purchase of the commodity on July 1. It closed out its position on July 1. What is the effective price (after taking account of hedging) paid by the company? A. $59.50 B. $60.50 C. $61.50 D. $63.50 Answer: A The user of the commodity takes a long futures position. The gain on the futures is 63.50−59 or $4.50. The effective paid realized is therefore 64−4.50 or $59.50. This can also be calculated as the March 1 futures price (=59) plus the basis on July 1 (=0.50). 4. On March 1 the price of a commodity is $1,000 and the December futures price is $1,015. On November 1 the price is $980 and the December futures price is $981. A producer of the commodity entered into a December futures contracts on March 1 to hedge the sale of the commodity on November 1. It closed out its position on November 1. What is the effective price (after taking account of hedging) received by the company for the commodity? A. $1,016 B. $1,001 C. $981 D. $1,014 Answer: D The producer of the commodity takes a short futures position. The gain on the futures is 1015−981 or $34. The effective price realized is therefore 980+34 or $1014. This can also be calculated as the March 1 futures price (=1015) plus the November 1 basis (=−1). 5. Suppose that the standard deviation of monthly change s in the price of commodity A is $2. The standard deviation of monthly changes in a futures price for a contract on commodity B (which is similar to commodity A) is $3. The correlation between the futures price and the commodity price is 0.9. What hedge ratio should be used when hedging a one month exposure to the price of commodity A? A. 0.60 B. 0.67 C. 1.45 D. 0.90 Answer: A The optimal hedge ratio is 0.9×(2/3) or 0.6. 6. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to reduce beta to 0.9? A. Long 192 contracts B. Short 192 contracts C. Long 48 contracts D. Short 48 contracts Answer: D To reduce the beta by 0.3 we need to short 0.3×36,000,000/(900×250) or 48 contracts. 7. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to increase beta to 1.8? A. Long 192 contracts A. Short 192 contracts B. Long 96 contracts C. Short 96 contracts Answer: C To increase beta by 0.6 we need to go long 0.6×36,000,000/(900×250) or 96 contracts 8. Which of the following is true? A. The optimal hedge ratio is the slope of the best fit line when the spot price (on the y-axis) is regressed against the futures price (on the x -axis). B. The optimal hedge ratio is the slope of the best fit line when the futures price (on the y-axis) is regressed against the spot price (on the x-axis). C. The optimal hedge ratio is the slope of the best fit line when the change in the spot price (on the y-axis) is regressed against the change in the futures price (on the x-axis). D. The optimal hedge ratio is the slope of the best fit line when the change in the futures price (on the y-axis) is regressed against the change in the spot price (on the x-axis). Answer: C The optimal hedge ratio reflects the ratio of movements in the spot price to movements in the futures price. 9. Which of the following describes tailing the hedge? A. A strategy where the hedge position is increased at the end of the life of the hedge B. A strategy where the hedge position is increased at the end of the life of the futures contract C. A more exact calculation of the hedge ratio when forward contracts are used for hedging D. None of the above Answer: D Tailing the hedge is a calculation appropriate when futures are used for hedging. It corrects for daily settlement 10. A company due to pay a certain amount of a foreign currency in the future decides to hedge with futures contracts. Which of the following best describes the advantage of hedging? A. It leads to a better exchange rate being paid B. It leads to a more predictable exchange rate being paid C. It caps the exchange rate that will be paid D. It provides a floor for the exchange rate that will be paid Answer: B Hedging is designed to reduce risk not increase expected profit. Options can be used to create a cap or floor on the price. Futures attempt to lock in the price 11. Which of the following best describes the capital asset pricing model? A. Determines the amount of capital that is needed in particular situations B. Is used to determine the price of futures contracts B. Relates the return on an asset to the return on a stock index C. Is used to determine the volatility of a stock index Answer: C CAPM relates the return on an asset to its beta. The parameter beta measures the sensitivity of the return on the asset to the return on the market. The latter is usually assumed to be the return on a stock index such as the S&P 500. 12. Which of the following best describes “stack and roll”? A. Creates long -term hedges from short term futures contracts B. Can avoid losses on futures contracts by entering into further futures contracts C. Involves buying a futures contract with one maturity and selling a futures contract with a different maturity D. Involves two different exposures simultaneously Answer: A Stack and roll is a procedure where short maturity futures contracts are entered into. When they are close to maturity they are replaced by more short maturity futures contracts and so on. The result is the creation of a long term hedge from short -term futures contracts. 13. Which of the following increases basis risk? A. A large difference between the futures prices when the hedge is put in place and when it is closed out B. Dissimilarity between the underlying asset of the futures contract and the hedger’s exposure C. A reduction in the time between the date when the futures contract is closed and its delivery month D. None of the above Answer: B Basis is the difference between spot and futures at the time the hedge is closed out. This increases as the time between the date when the futures contract is put in place and the delivery month increases. (C is not therefore correct). It also increases as the asset underlying the futures contract becomes more different from the asset being hedged. (B is therefore correct.) 14. Which of the following is a reason for hedging a portfolio with an index futures? A. The investor believes the stocks in the portfolio will perform better than the market but is uncertain about the future performance of the market B. The investor believes the stocks in the portfolio will perform better than the market and the market is expected to do well C. The portfolio is not well diversified and so its return is uncertain D. All of the above Answer: A Index futures can be used to remove the impact of the performance of the overall market on the portfolio. If the market is expected to do well hedging against the performance of the market is not appropriate. Hedging cannot correct for a poorly diversified portfolio. 15. Which of the following does NOT describe beta? A. A measure of the sensitivity of the return on an asset to the return on an index B. The slope of the best fit line when the return on an asset is regressed against the return on the market C. The hedge ratio necessary to remove market risk from a portfolio D. Measures correlation between futures prices and spot prices for a commodity Answer: D A, B, and C all describe beta but beta has nothing to do with the correlation between futures and spot prices for a commodity 16. Which of the following is true? A. Hedging can always be done more easily by a company’s shareholders than by the company itself B. If all companies in an industry hedge, a company in the industry can sometimes reduce its risk by choosing not to hedge C. If all companies in an industry do not hedge, a company in the industry can reduce its risk by hedging D. If all companies in an industry do not hedge, a company is liable increase its risk by hedging Answer: D If all companies in a industry hedge, the price of the end product tends to reflect movements in relevant market variables. Attempting to hedge those movements can therefore increase risk. 17. Which of the following is necessary for tailing a hedge? A. Comparing the size in units of the position being hedged with the size in units of the futures contract B. Comparing the value of the position being hedged with the value of one futures contract C. Comparing the futures price of the asset being hedged to its forward price D. None of the above Answer: B When tailing a hedge the optimal hedge ratio is applied to the ratio of the value of the position being hedged to the value of one futures contract. 18. Which of the following is true? A. Gold producers should always hedge the price they will receive for their production of gold over the next three years B. Gold producers should always hedge the price they will receive for their production of gold over the next one year C. The hedging strategies of a gold producer should depend on whether it shareholders want exposure to the price of gold D. Gold producers can hedge by buying gold in the forward market Answer: C Some shareholders buy gold stocks to gain exposure to the price of gold. They do not want the company they invest in to hedge. In practice gold mining companies make their hedging strategies clear to shareholders. 19. A silver mining company has used futures markets to hedge the price it will receive for everything it will produce over the next 5 years. Which of the following is true? A. It is liable to experience liquidity problems if the price of silver falls dramatically B. It is liable to experience liquidity problems if the price of silver rises dramatically C. It is liable to experience liquidity problems if the price of silver rises dramatically or falls dramatically D. The operation of futures markets protects it from liquidity problems Answer: B The mining company shorts futures. It gains on the futures when the price decreases and loses when the price increases. It may get margin calls which lead to liquidity problems when the price rises even though the silver in the ground is worth more. 20. A company will buy 1000 units of a certain commodity in one year. It decides to hedge 80% of its exposure using futures contracts. The spot price and the futures price are currently $100 and $90, respectively. The spot price and the futures price in one year turn out to be $112 and $110, respectively. What is the average price paid for the commodity? A. $92 B. $96 C. $102 D. $106 Answer: B On the 80% (hedged) part of the commodity purchase the price paid will 112−(110−90) or $92. On the other 20% the price paid will be the spot price of $112. The weighted average of the two prices is 0.8×92+0.2×112 or $96. Hull: Options, Futures and Other Derivatives, Ninth Edition, Global Edition Chapter 4: Interest Rates Multiple Choice Test Bank: Questions with Answers 1. The compounding frequency for an interest rate defines E. The frequency with which interest is paid F. A unit of measurement for the interest rate G. The relationship between the annual interest rate and the monthly interest rate H. None of the above Answer: B The compounding frequency is a unit of measurement. The frequency with which interest is paid may be different from the compounding frequency used for quoting the rate. 21. An interest rate is 6% per annum with annual compounding. What is the equivalent rate with continuous compounding? A. 5.79% B. 6.21% C. 5.83% D. 6.18% Answer: C The equivalent rate with continuous compounding is ln(1.06) = 0.0583 or 5.83%. 22. An interest rate is 5% per annum with continuous compounding. What is the equivalent rate with semiannual compounding? A. 5.06% B. 5.03% C. 4.97% D. 4.94% Answer: A The equivalent rate with semiannual compounding is 2×(e0.05/2−1) = 0.0506 or 5.06%. 23. An interest rate is 12% per annum with semiannual compounding. What is the equivalent rate with quarterly compounding? A. 11.83% B. 11.66% C. 11.77% D. 11.92% Answer: A 1.06 The equivalent rate per quarter is - 1 =2.956% . The annualized rate with quarterly compounding is four times this or 11.83%. 24. The two-year zero rate is 6% and the three year zero rate is 6.5%. What is the forward rate for the third year? All rates are continuously compounded. A. 6.75% B. 7.0% C. 7.25% D. 7.5% Answer: D The forward rate for the third year is (3×0.065−2×0.06)/(3−2) = 0.075 or 7.5%. 25. The six-month zero rate is 8% per annum with semiannual compounding. The price of a one-year bond that provides a coupon of 6% per annum semiannually is 97. What is the one -year continuously compounded zero rate? A. 8.02% B. 8.52% C. 9.02% D. 9.52% Answer: C If the rate is R we must have or 3 1.04 +103e- R×1 =97 e- R =97 - 3/1.04 =0.9137 103 so that R = ln(1/0.9137) = 0.0902 or 9.02%. 26. The yield curve is flat at 6% per annum. What is the value of an FRA where the holder receives interest at the rate of 8% per annum for a six-month period on a principal of $1,000 starting in two years? All rates are compounded semiannually. A. $9.12 B. $9.02 C. $8.88 D. $8.63 Answer: D The value of the FRA is the value of receiving an extra 0.5×(0.08−0.06)×1000 = $10 in 2.5 years. This is 10/(1.035) = $8.63. 27. Under liquidity preference theory, which of the following is always true? A. The forward rate is higher than the spot rate when both have the same maturity. B. Forward rates are unbiased predictors of expected future spot rates. C. The spot rate for a certain maturity is higher than the par yield for that maturity. D. Forward rates are higher than expected future spot rates. Answer: D Liquidity preference theory argues that individual s like their borrowings to have a long maturity and their deposits to have a short maturity. To induce people to lend for long periods forward rates are raised relative to what expected future short rates would predict. 28. The zero curve is upward sloping. Define X as the 1-year par yield, Y as the 1-year zero rate and Z as the forward rate for the period between 1 and 1.5 year. Which of the following is true? A. X is less than Y which is less than Z B. Y is less than X which is less than Z C. X is less than Z which is less than Y D. Z is less than Y which is less than X Answer: A When the zero curve is upward sloping, the one -year zero rate is higher than the one -year par yield and the forward rate corresponding to the period between 1.0 and 1.5 years is higher than the one-year zero rate. The correct answer is therefore A. 29. Which of the following is true of the fed funds rate A. It is the same as the Treasury rate B. It is an overnight interbank rate C. It is a rate for which collateral is posted D. It is a type of repo rate Answer: B At the end of each day some banks have surplus reserves on deposit with the Federal Reserve others have deficits. They use overnight borrowing and lending at what is termed the fed funds rate to rectify this. 30. The modified duration of a bond portfolio worth $1 million is 5 years. By approximately how much does the value of the portfolio change if all yields increase by 5 basis points? A. Increase of $2,500 B. Decrease of $2,500 C. Increase of $25,000 D. Decrease of $25,000 Answer: B When yields increase bond prices decrease. The proportional decrease is the modified duration times the yield increase. In this case, it is 5×0.0005=0.0025. The decrease is therefore 0.0025×1,000,000 or $2,500. 31. A company invests $1,000 in a five-year zero -coupon bond and $4,000 in a ten-year zero - coupon bond. What is the duration of the portfolio? A. 6 years B. 7 years C. 8 years D. 9 years Answer: D The duration of the first bond is 5 years and the duration of the second bond is 10 years. The duration of the portfolio is a weighted average with weights corresponding to the amounts invested in the bonds. It is 0.2×5+0.8×10=9 years. 32. Which of the following is true of LIBOR A. The LIBOR rate is free of credit risk B. A LIBOR rate is lower than the Treasury rate when the two have the same maturity C. It is a rate used when borrowing and lending takes place between banks D. It is subject to favorable tax treatment in the U.S. Answer: C LIBOR is a rate used for interbank transactions. 33. Which of following describes forward rates? A. Interest rates implied by current zero rates for future periods of time B. Interest rate earned on an investment that starts today and last for n -years in the future without coupons C. The coupon rate that causes a bond price to equal its par (or principal) value D. A single discount rate that gives the value of a bond equal to its market price when applied to all cash flows Answer: A The forward rate is the interest rate implied by the current term structure for future periods of time. For example, earning the zero rate for one year and the forward rate for the period between one and two years gives the same result as earning the zero rate for two years. 34. Which of the following is NOT a theory of the term structure A. Expectations theory B. Market segmentation theory C. Liquidity preference theory D. Maturity preference theory Answer: C Maturity preference theory is not a theory of the term structure. The other three are. 35. A repo rate is A. An uncollateralized rate B.A rate where the credit risk is relative high C.The rate implicit in a transaction where securities are sold and bought back later at a higher price D.None of the above Answer: C A repo transaction is one where a company agrees to sell securities today and buy them back at a future time. It is a form of collateralized borrowing. The credit risk is very low. 36. Bootstrapping involves A. Calculating the yield on a bond B. Working from short maturity instruments to longer maturity instruments determining zero rates at each step C. Working from long maturity instruments to shorter maturity instruments determining zero rates at each step D.The calculation of par yields Answer: B Bootstrapping is a way of constructing the zero coupon yield curve from coupon -bearing bonds. It involves working from the shortest maturity bond to progressively longer maturity bonds making sure that the calculated zero coupon yield curve is consistent with the market prices of the instruments. 37. The zero curve is downward sloping. Define X as the 1 -year par yield, Y as the 1 -year ze ro rate and Z as the forward rate for the period between 1 and 1.5 year. Which of the following is true? A. X is less than Y which is less than Z B. Y is less than X which is less than Z C. X is less than Z which is less than Y D. Z is less than Y which is less than X Answer: D The forward rate accentuates trends in the zero curve. The par yield shows the same trends but in a less pronounced way. 38. Which of the following is true? A. When interest rates in the economy increase, all bond prices increase B. As its coupon increases, a bond’s price decreases C. Longer maturity bonds are always worth more that shorter maturity bonds when the coupon rates are the same D. None of the above Answer: D When interest rates increase the impact of discounting is to make future cash flows worth less. Bond prices therefore decline. A is therefore wrong. As coupons increase a bond becomes more valuable because higher cash flows will be received. B is therefore wrong. When the coupon is higher than prevailing interest rates, longer maturity bonds are worth more than shorter maturity bonds. When it is less than prevailing interest rates, longer maturity bonds are worth less than shorter maturity bonds. C is therefore not true. The correct answer is therefore D. 39. The six month and one-year rates are 3% and 4% per annum with semiannual compounding. Which of the following is closest to the one -year par yield expressed with semiannual compounding? A. 3.99% B. 3.98% C. 3.97% D. 3.96% Answer: A The six month rate is 1.5% per six months. The one year rate is 2% per six months. The one year par yield is the coupon that leads to a bond being worth par. A is the correct answer because (3.99/2)/1.015+(100+3.99/2)/1.022 = 100. The formula in the text can also be used to give the par yield as [(100 -100/1.022)×2]/(1/1.015+1.022)=3.99.