Point to Remember 34

[Avishek]

A bank can create an on-balance-sheet hedged position by matching:

A) domestic and foreign cash rate exposure on its balance sheet.

B) domestic and foreign inflation rate exposure on its balance sheet.

C) domestic and foreign market value positions on its balance sheet.

D) maturity and currency positions on its balance sheet.



Your answer: D was correct!

By matching both the maturity and currency positions on its balance sheet, the bank has created a situation where a net return is essentially locked in, no matter what happens to the exchange rate.

 

[Avishek]

Short-dated futures contracts are most effective for hedging which type of foreign exchange exposure?

A) Transactions exposure.

B) Translation exposure.

C) Competitive exposure.

D) Quantity exposure.



Your answer: A was correct!

Transactions exposure is related to receivables and payables that are already booked. Thus, transactions exposure represents known, short-term cash flows that can be effectively hedged.

 

[Avishek]

A U.S.-based company exports consumer goods to Britain and is concerned with the U.S. dollar value of revenue from British sales. A futures hedge is unnecessary if British pound revenues:

A) have a correlation with the value of the pound of +0.5.

B) are perfectly positively correlated with the value of the pound.

C) are perfectly negatively correlated with the value of the pound.

D) are uncorrelated with the value of the pound.



Your answer: C was correct!

If pound revenues are perfectly negatively correlated with the value of the pound, there is no need to hedge, as the dollar value of pound revenues is constant.

 

[Avishek]

You are assessing your companys exposure to exchange rate fluctuations. Your immediate concern is the impact of future exchange rate movements on future exports to Europe. This is an example of:

A) competitive exposure.

B) price exposure.

C) contractual exposure.

D) transactions exposure.



Your answer: A was correct!

Competitive exposure is the sensitivity of the firms cash flow to a change in the risk factor resulting from changes in the firms competitive position.

 

[Avishek]

Assume that the short-term interest rate in London is 4 percent and that the short-term interest rate in the US is 2 percent. If the current exchange rate between the euro and dollar is 1=US$1.2217, using the continuous time futures pricing model, what is the price of a three-month futures contract?

A) $1.2207.

B) $1.2144.

C) $1.2156.

D) $1.2235.



Your answer: B was incorrect. The correct answer was C) $1.2156.

The formula is: 1.2217e(0.02-0.04)(0.25) = $1.2156.

Foreign currencies are similar to index futures when it comes to computing the futures price. Since exchange rates are driven by interest-rate differentials, the exchange rate can be treated as an asset that pays a continuous rate, rf . More simply, interest-rate parity states that the forward exchange rate (measured in $/ unit of foreign currency), F, must be related to the spot exchange rate, S, and the interest-rate differential between the U.S. and the foreign country.

 

[Avishek]

A corn grower is concerned that the price he can get from the field in mid-September will be less than he has forecasted. To protect himself from price declines, the farmer has decided to hedge. The best available futures contract he can find is for August delivery. Which of the following is the appropriate direction of his position and the source of basis risk that may impact the farmer?

A) Short futures; correlation.

B) Long futures; correlation.

C) Short futures; rollover.

D) Long futures; rollover.



Your answer: C was correct!

The farmer needs to be short the futures contracts. The source of basis risk for this farmer arises from the fact that his contract and harvest dates do not perfectly match. As a result, he will be exposed to basis risk due to a necessary rollover in his position.

 

[Avishek]

How will the value of a portfolio of non-callable corporate bonds hedged with Treasury futures change if the yield curve shifts up in a parallel manner by an anticipated amount? The value of the newly hedged portfolio:

A) stays the same.

B) may increase or decrease.

C) increases.

D) decreases.



Your answer: A was correct!

The portfolio is hedged against parallel movements in the yield curve so its value will not change.

 

[Avishek]

A weakening of the basis is a consequence of the:

A) spot price increasing faster than the futures price over time.

B) spot price moving according to hyper-arithmetic Brownian motion.

C) futures price moving according to hyper-arithmetic Brownian motion.

D) futures price increasing faster than the spot price over time.



Your answer: D was correct!

Basis is defined as the difference between the spot price and the futures price. Weakening of the basis occurs when the futures price increases relatively faster than the spot price

 

[Avishek]

Which of the following commodities is an example of seasonal production and constant demand?

A) Gold.

B) Natural gas.

C) Oil.

D) Corn.



Your answer: B was incorrect. The correct answer was D) Corn.

Corn is an example of a commodity with seasonal production and a constant demand. Corn is produced in the fall of every year, but it is consumed throughout the year.

 

[Avishek]

Which of the following is a difference between a strip and a stack hedge? A stack hedge uses:

A) out-of-the money put options.

B) futures contracts that are concentrated in a single futures expiration.

C) a combination of long and short positions in different futures expirations.

D) futures contracts on assets that are related to, but different, from the hedged asset.



Your answer: B was correct!

 

[Avishek]

A forward rate agreement (FRA):

A) is risk-free when based on the Treasury bill rate.

B) is priced in dollars.

C) is settled by making a loan at the contract rate.

D) can be used to hedge the interest rate exposure of a floating-rate loan.



Your answer: D was correct!

An FRA settles in cash and carries both default risk and interest rate risk, even when based on an essentially risk-free rate. It can be used to hedge the risk/uncertainty about a future payment on a floating rate loan.

 

[Avishek]

Two banks enter into a 1-year plain vanilla interest-rate swap with the following terms:

Notional principal is $500,000,000.

The fixed component of the swap is 7%, which is the current market rate.

The floating component of the swap is LIBOR + 200bps.

If the current risk-free rate is 4 percent, the value for this swap at inception is closest to:

A) $500,000,000.

B) $0.

C) $8,750,000.

D) $35,000,000.



Your answer: B was correct!

The initial value of a swap is always zero. As interest rates move and payments take place, the value of the swap will change for both parties.

 

[Avishek]

The credit risks to the fixed-rate payer in a swap:

A) increase when floating rates are below the swap rate.

B) are greatest at the inception of the swap.

C) are greatest just prior to maturity.

D) increase when floating rates rise above the swap rate.



Your answer: D was correct!

When floating rates rise above the swap rate, the fixed rate side of the swap will have positive value, and the credit risk borne by the fixed-rate payer will increase. At the inception of the swap, the value to both sides is zero, and just prior to maturity, when only one net payment remains, credit risk is relatively small.

 

[Avishek]

In a standard interest rate swap, the floating rate payments to be made at the end of each period are determined:

A) at the beginning of the period.

B) at the end of the period.

C) by the parties at inception of the swap.

D) by the parties at the conclusion of the swap.



Your answer: C was incorrect. The correct answer was A) at the beginning of the period.

In a standard swap, the interest rate used to determine the floating rate payment is set at the beginning of each period.

 

[Avishek]

Which statement best reflects the risk exposure of a put writer?

A) No risk.

B) Unlimited risk.

C) Limited risk.

D) Conditional risk tied to tax law.



Your answer: C was correct!

Because stock prices cannot fall below $0, a put writers risk is limited to the strike price.

 

[Avishek]

The initial and maintenance margins for U.S. exchange-traded long call and put options are, respectively:

A) 25%; 25%.

B) 50%; 50%.

C) Options cannot be purchased on margin.

D) 50%; 25%.



Your answer: C was correct!

Long calls and puts require the full amount of the purchase price because options already contain substantial leverage. They cannot be purchased on margin.

 

[Avishek]

It may be attractive to exercise an American put option prior to expiration when the underlying stock price is:

A) much lower than the exercise price and risk-free rates are positive.

B) close to the strike price and risk-free rates are positive.

C) above the strike price and risk-free rates are close to zero.

D) close to the strike price and risk-free rates are close to zero.



Your answer: A was correct!

It can be shown that American put options on non-dividend paying stocks may be exercised early if the underlying stock price is sufficiently low. The owner of the option would essentially receive the strike price, which is the maximum value of the option, and could reinvest the proceeds at the risk-free rate, which would generate a payoff received today as opposed to in the future.

 

[Avishek]

Which of the following has the same impact on both American call and put option prices?


I. An increase in volatility.
II. An increase in the stock price.
III. An increase in the risk-free rate.
IV. A decrease in time to expiration.

A) I and IV.

B) I only.

C) I and II.

D) I and III.



Your answer: A was correct!

Increased volatility positively influences put and call option values, while a decrease in time to expiration will negatively influence call and put prices. Note that an increase in the stock price and an increase in the risk-free rate will cause the price of an American call to increase but will cause the price of an American put to decrease.

 

[Avishek]

For American options prior to maturity, the difference between the price of a call option and the price of a put option with the same underlying stock, strike price, and maturity must be less than or equal to the:

A) stock price minus the exercise price.

B) present value of exercise price minus stock price.

C) exercise price minus stock price.

D) stock price minus the present value of the exercise price.



Your answer: B was incorrect. The correct answer was D) stock price minus the present value of the exercise price.

The following relationship must hold for American options:


S0 - X ≤ C - P ≤ S0 - Xe-rt

 

[Avishek]

ABEX Corporation common stock is selling for $50.00 per share. Both an American call option and a European call option are available on ABEX common, and each have identical strike prices and expiration dates. Which of the following statements concerning these two options is TRUE?

A) Because the American and European options have identical terms and are written against the same common stock, they will have identical option premiums.


B) The greater flexibility allowed in exercising the American option will normally result in a higher market value relative to an otherwise identical European option.


C) The American option will have a higher option premium, because the American security markets are larger than the European markets.


D) The European option will normally have a higher option premium because of their relative scarcity compared to American options.




Your answer: B was correct!


Trading in European options is considerably less than trading in American options, because demand for them is much lower. This is due to their relative inflexibility regarding when they can be exercised. The greater exercising flexibility of American options gives them increased value to traders, which normally results in a greater market value relative to an otherwise identical European option.