Financial Derivatives Explained

186Frederic S.
MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition
Chapter 13
Financial Derivatives
)1
Multiple Choice
()a
()b
()c
()d
()e
()f
The payoffs for financial derivatives are linked to

securities that will be issued in the future.
the volatility of interest rates.
previously issued securities.
government regulations specifying allowable rates of return.
none of the above.
Answer:
Question Status: New
()g
()h
()i
()j
()k
Financial derivatives include

stocks.
bonds.
futures.
none of the above.
Answer:
Question Status: Previous Edition
()l
Financial derivatives include
()m stocks.
()n bonds.
()o forward contracts.
()p both (a) and (b) are true.
Answer:
()q
()r
()s
()t
()u
Which of the following is not a financial derivative?

Stock
Futures
Options
Forward contracts
Answer:
187Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition
()v
By hedging a portfolio, a bank manager
()w reduces interest rate risk.
()x increases reinvestment risk.
()y increases exchange rate risk.
()z increases the probability of gains.
Answer:
()aa
Which of the following is a reason to hedge a portfolio?
()bb
To increase the probability of gains.
()ccTo limit exposure to risk.
()dd
To profit from capital gains when interest rates fall.
()eeAll of the above.
()ff Both (a) and (c) of the above.
Answer:
Question Status: Revised
()gg
Hedging risk for a long position is accomplished by
()hh
taking another long position.
()ii taking a short position.
()jj taking additional long and short positions in equal amounts.
()kk
taking a neutral position.
()ll none of the above.
Answer:
()mm Hedging risk for a short position is accomplished by
()nn
taking a long position.
()oo
taking another short position.
()pp
taking additional long and short positions in equal amounts.
()qq
taking a neutral position.
()rr none of the above.
Answer:
()ss
A contract that requires the investor to buy securities on a future date is called a
()tt short contract.
()uu
long contract.
()vv
hedge.
()ww cross.
Answer:
Chapter 13Financial Derivatives188
()xx
A long contract requires that the investor
()yy
sell securities in the future.
()zzbuy securities in the future.
()aaa hedge in the future.
()bbb close out his position in the future.
Answer:
()ccc
()ddd
()eee
()fff
()ggg
()hhh
A person who agrees to buy an asset at a future date has gone

long.
short.
back.
ahead.
even.
Answer:
Question Status: Study Guide
()iii
A short contract requires that the investor
()jjj sell securities in the future.
()kkk buy securities in the future.
()lll hedge in the future.
()mmm close out his position in the future.
Answer:
()nnn
()ooo
()ppp
()qqq
()rrr
A contract that requires the investor to sell securities on a future date is called a
short contract.
long contract.
hedge.
micro hedge.
Answer:
()sss If a bank manager chooses to hedge his portfolio of treasury securities by selling futures
contracts, he
()ttt gives up the opportunity for gains.
()uuu removes the chance of loss.
()vvv increases the probability of a gain.
()www both (a) and (b) are true.
Answer:
()xxx
()yyy
()zzz
()aaaa
()bbbb
()cccc
To say that the forward market lacks liquidity means that

forward contracts usually result in losses.
forward contracts cannot be turned into cash.
it may be difficult to make the transaction.
forward contracts cannot be sold for cash.
none of the above.
Answer:
()dddd
()eeee
()ffff
()gggg
()hhhh
()iiii
A disadvantage of a forward contract is that

it may be difficult to locate a counterparty.
the forward market suffers from lack of liquidity.
these contracts have default risk.
all of the above.
both (a) and (c) of the above.
Answer:
()jjjj Forward contracts are risky because they
()kkkk are subject to lack of liquidity
()llll
are subject to default risk.
()mmmm hedge a portfolio.
()nnnn both (a) and (b) are true.
Answer:
()oooo
()pppp
()qqqq
()rrrr
()ssss
The advantage of forward contracts over future contracts is that they

are standardized.
have lower default risk.
are more liquid.
none of the above.
Answer:
()tttt
The advantage of forward contracts over futures contracts is that they
()uuuu are standardized.
()vvvv have lower default risk.
()wwww are more flexible.
()xxxx both (a) and (b) are true.
Answer:
()yyyy Forward contracts are of limited usefulness to financial institutions because

()zzzz of default risk.
()aaaaa it is impossible to hedge risk.
()bbbbb of lack of liquidity.
()ccccc all of the above.
()ddddd both (a) and (c) of the above.
Answer:
()eeeee Futures contracts are regularly traded on the
()fffff Chicago Board of Trade.
()ggggg New York Stock Exchange.
()hhhhh American Stock Exchange.
()iiiii Chicago Board of Options Exchange.
Answer:
()jjjjj Hedging in the futures market
()kkkkk eliminates the opportunity for gains.
()lllll eliminates the opportunity for losses.
()mmmmm
increases the earnings potential of the portfolio.
()nnnnn does all of the above.
()ooooo does both (a) and (b) of the above.
Answer:
()ppppp When interest rates fall, a bank that perfectly hedges its portfolio of Treasury securities in
the futures market
()qqqqq suffers a loss.
()rrrrr experiences a gain.
()sssss has no change in its income.
()ttttt none of the above.
Answer:
()uuuuu Futures markets have grown rapidly because futures
()vvvvv are standardized.
()wwwww
have lower default risk.
()xxxxx are liquid.
()yyyyy all of the above.
Answer:
()zzzzz Parties who have bought a futures contract and thereby agreed to _____ (take delivery of)
the bonds are said to have taken a ____ position.
()aaaaaa sell; short
()bbbbbb buy; short
()cccccc sell; long
()dddddd buy; long
Answer:
()eeeeee Parties who have sold a futures contract and thereby agreed to _____ (deliver) the bonds
are said to have taken a ____ position.
()ffffff sell; short
()gggggg buy; short
()hhhhhh sell; long
()iiiiii buy; long
Answer:
()jjjjjj By selling short a futures contract of $100,000 at a price of 115 you are agreeing to deliver
()kkkkkk $100,000 face value securities for $115,000.
()llllll $115,000 face value securities for $110,000.
()mmmmmm
$100,000 face value securities for $100,000.
()nnnnnn $115,000 face value securities for $115,000.
Answer:
()oooooo By selling short a futures contract of $100,000 at a price of 96 you are agreeing to deliver
()pppppp $100,000 face value securities for $104,167.
()qqqqqq $96,000 face value securities for $100,000.
()rrrrrr $100,000 face value securities for $96,000.
()ssssss $96,000 face value securities for $104,167.
Answer:
()tttttt By buying a long $100,000 futures contract for 115 you agree to pay
()uuuuuu $100,000 for $115,000 face value bonds.
()vvvvvv $115,000 for $100,000 face value bonds.
()wwwwww
$86,956 for $100,000 face value bonds.
()xxxxxx $86,956 for $115,000 face value bonds.
Answer:
()yyyyyy On the expiration date of a futures contract, the price of the contract
()zzzzzz always equals the purchase price of the contract.
()aaaaaaa always equals the average price over the life of the contract.
()bbbbbbb
always equals the price of the underlying asset.
()ccccccc always equals the average of the purchase price and the price of underlying asset.
()ddddddd
cannot be determined.
Answer:
()eeeeeee The price of a futures contract at the expiration date of the contract
()fffffff equals the price of the underlying asset.
()ggggggg
equals the price of the counterparty.
()hhhhhhh
equals the hedge position.
()iiiiiii equals the value of the hedged asset.
()jjjjjjj none of the above.
Answer:
()kkkkkkk
()lllllll hedging.
()mmmmmmm
()nnnnnnn
()ooooooo
()ppppppp
Elimination of riskless profit opportunities in the futures market is

arbitrage.
speculation.
underwriting.
diversification.
Answer:
()qqqqqqq
If you purchase a $100,000 interest-rate futures contract for 110, and the price of
the Treasury securities on the expiration date is 106
()rrrrrrr your profit is $4000.
()sssssss your loss is $4000.
()ttttttt your profit is $6000.
()uuuuuuu
your loss is $6000.
()vvvvvvv
your profit is $10,000.
Answer:
()wwwwwww
If you purchase a $100,000 interest-rate futures contract for 105, and the price of
the Treasury securities on the expiration date is 108
()xxxxxxx
your profit is $3000.
()yyyyyyy
your loss is $3000.
()zzzzzzz your profit is $8000.
()aaaaaaaa
your loss is $8000.
()bbbbbbbb
Answer:
()cccccccc
If you sell a $100,000 interest-rate futures contract for 110, and the price of the
Treasury securities on the expiration date is 106
()dddddddd
()eeeeeeee
your loss is $4000.
()ffffffffyour profit is $6000.
()gggggggg
your loss is $6000.
()hhhhhhhh
your profit is $10,000.
Answer:
()iiiiiiii If you sell a $100,000 interest-rate futures contract for 105, and the price of the Treasury
securities on the expiration date is 108
()jjjjjjjj your profit is $3000.
()kkkkkkkk
your loss is $3000.
()llllllll your profit is $8000.
()mmmmmmmm your loss is $8000.
()nnnnnnnn
Answer:
()oooooooo
If you sold a short contract on financial futures you hope interest rates
()pppppppp
rise.
()qqqqqqqq
fall.
()rrrrrrrr are stable.
()ssssssss fluctuate.
Answer:
()tttttttt If you sold a short futures contract you will hope that interest rates
()uuuuuuuu
rise.
()vvvvvvvv
fall.
()wwwwwwww are stable.
()xxxxxxxx
fluctuate.
Answer:
()yyyyyyyy
()zzzzzzzz
()aaaaaaaaa
()bbbbbbbbb
()ccccccccc
If you bought a long contract on financial futures you hope that interest rates
rise.
fall.
are stable.
fluctuate.
Answer:
()ddddddddd
()eeeeeeeee
()fffffffff fall.
()ggggggggg
()hhhhhhhhh
If you bought a long futures contract you hope that bond prices
rise.
are stable.
fluctuate.
Answer:
()iiiiiiiii If you sold a short futures contract you will hope that bond prices
()jjjjjjjjj rise.
()kkkkkkkkk
fall.
()lllllllll are stable.
()mmmmmmmmm
fluctuate.
Answer:
()nnnnnnnnn
To hedge the interest rate risk on $4 million of Treasury bonds with $100,000
futures contracts, you would need to purchase
()ooooooooo
4 contracts.
()ppppppppp
20 contracts.
()qqqqqqqqq
25 contracts.
()rrrrrrrrr 40 contracts.
()sssssssss
400 contracts.
Answer:
()ttttttttt If you sell twenty-five $100,000 futures contracts to hedge holdings of a Treasury security,
the value of the Treasury securities you are holding is
()uuuuuuuuu
$250,000.
()vvvvvvvvv
$1,000,000.
()wwwwwwwww $2,500,000.
()xxxxxxxxx
$5,000,000.
()yyyyyyyyy
$25,000,000.
Answer:
()zzzzzzzzz
Assume you are holding Treasury securities and have sold futures to hedge
against interest rate risk. If interest rates rise
()aaaaaaaaaa
the increase in the value of the securities equals the decrease in the value of the
futures contracts.
()bbbbbbbbbb
the decrease in the value of the securities equals the increase in the value of the
futures contracts.
()cccccccccc
the increase ion the value of the securities exceeds the decrease in the values of
the futures contracts.
()dddddddddd
both the securities and the futures contracts increase in value.
()eeeeeeeeee
both the securities and the futures contracts decrease in value
Answer:
()ffffffffff Assume you are holding Treasury securities and have sold futures to hedge against interest
rate risk. If interest rates fall
()gggggggggg
the increase in the value of the securities equals the decrease in the value of the
futures contracts.
()hhhhhhhhhh
the decrease in the value of the securities equals the increase in the value of the
futures contracts.
()iiiiiiiiii the increase in the value of the securities exceeds the decrease in the values of the futures
contracts.
()jjjjjjjjjj both the securities and the futures contracts increase in value.
()kkkkkkkkkk
both the securities and the futures contracts decrease in value.
Answer:
()llllllllll When a financial institution hedges the interest-rate risk for a specific asset, the hedge is
called a
()mmmmmmmmmm
macro hedge.
()nnnnnnnnnn
micro hedge.
()oooooooooo
cross hedge.
()pppppppppp
futures hedge.
Answer:
()qqqqqqqqqq
When the financial institution is hedging interest-rate risk on its overall portfolio,
then the hedge is a
()rrrrrrrrrrmacro hedge.
()ssssssssss
micro hedge.
()tttttttttt cross hedge.
()uuuuuuuuuu
futures hedge.
Answer:
()vvvvvvvvvv
The number of futures contracts outstanding is called
()wwwwwwwwww
liquidity.
()xxxxxxxxxx
volume.
()yyyyyyyyyy
float.
()zzzzzzzzzz
open interest.
()aaaaaaaaaaa
turnover.
Answer:
()bbbbbbbbbbb
liquidity?
()ccccccccccc
()ddddddddddd
()eeeeeeeeeee
()fffffffffff
Which of the following features of futures contracts were not designed to increase
Standardized contracts
Traded up until maturity
Not tied to one specific type of bond
Marked to market daily
Answer:
()ggggggggggg Which of the following features of futures contracts were not designed to increase
liquidity?
()hhhhhhhhhhh Standardized contracts
()iiiiiiiiiii Traded up until maturity
()jjjjjjjjjjj Not tied to one specific type of bond
()kkkkkkkkkkk Can be closed with off setting trade
Answer:
()lllllllllll Futures differ from forwards because they are
()mmmmmmmmmmm used to hedge portfolios.
()nnnnnnnnnnn used to hedge individual securities.
()ooooooooooo used in both financial and foreign exchange markets.
()ppppppppppp a standardized contract.
Answer:
()qqqqqqqqqqq Futures differ from forwards because they are
()rrrrrrrrrrr
used to hedge portfolios.
()sssssssssss
used to hedge individual securities.
()ttttttttttt used in both financial and foreign exchange markets.
()uuuuuuuuuuu marked to market daily.
Answer:
()vvvvvvvvvvv The advantage of futures contracts relative to forward contracts is that futures
contracts
()wwwwwwwwwww
are standardized, making it easier to match parties, thereby increasing
liquidity.
()xxxxxxxxxxx specify that more than one bond is eligible for delivery, making it harder for
someone to corner the market and squeeze traders.
()yyyyyyyyyyy cannot be traded prior to the delivery date, thereby increasing market liquidity.
()zzzzzzzzzzz
all of the above.
()aaaaaaaaaaaa both (a) and (b) of the above.
Answer:
()bbbbbbbbbbbb If a firm is due to be paid in deutsche marks in two months, to hedge against
exchange rate risk the firm should
()cccccccccccc sell foreign exchange futures short.
()dddddddddddd buy foreign exchange futures long.
()eeeeeeeeeeee stay out of the exchange futures market.
()ffffffffffff
none of the above.
Answer:
()gggggggggggg If a firm must pay for goods it has ordered with foreign currency, it can hedge its
foreign exchange rate risk by
()hhhhhhhhhhhh selling foreign exchange futures short.
()iiiiiiiiiiiibuying foreign exchange futures long.
()jjjjjjjjjjjjstaying out of the exchange futures market.
()kkkkkkkkkkkk none of the above.
Answer:
()llllllllllllIf a firm is due to be paid in deutsche marks in two months, to hedge against exchange
rate risk the firm should _____ foreign exchange futures _____.
()mmmmmmmmmmmm sell; short
()nnnnnnnnnnnn buy; long
()oooooooooooo sell; long
()pppppppppppp buy; short
Answer:
()qqqqqqqqqqqq If a firm must pay for goods it has ordered with foreign currency, it can hedge its
foreign exchange rate risk by _____ foreign exchange futures _____.
()rrrrrrrrrrrr
selling; short
()ssssssssssss
buying; long
()ttttttttttttbuying; short
()uuuuuuuuuuuu selling; long
Answer:
()vvvvvvvvvvvv Options are contracts that give the purchasers the
()wwwwwwwwwwww option to buy or sell an underlying asset.
()xxxxxxxxxxxx the obligation to buy or sell an underlying asset.
()yyyyyyyyyyyy the right to hold an underlying asset.
()zzzzzzzzzzzz the right to switch payment streams.
Answer:
()aaaaaaaaaaaaa The price specified on an option that the holder can buy or sell the underlying
asset is called the
()bbbbbbbbbbbbb premium.
()ccccccccccccc call.
()ddddddddddddd strike price.
()eeeeeeeeeeeee put.
Answer:
()fffffffffffff
The price specified on an option that the holder can buy or sell the underlying
asset is called the
()ggggggggggggg premium.
()hhhhhhhhhhhhh strike price.
()iiiiiiiiiiiii
exercise price.
()jjjjjjjjjjjjj
both (b) and (c) are true.
Answer:
()kkkkkkkkkkkkk The seller of an option has the
()lllllllllllll
right to buy or sell the underlying asset.
()mmmmmmmmmmmmm
the obligation to buy or sell the underlying asset.
()nnnnnnnnnnnnn ability to reduce transaction risk.
()ooooooooooooo right to exchange one payment stream for another.
Answer:
()ppppppppppppp The seller of an option is ______ to buy or sell the underlying asset while the
purchaser of an option has the ______ to buy or sell the asset.
()qqqqqqqqqqqqq obligated; right
()rrrrrrrrrrrrr
right; obligation
()sssssssssssss
obligated; obligation
()ttttttttttttt
right; right
Answer:
()uuuuuuuuuuuuu The amount paid for an option is the
()vvvvvvvvvvvvv strike price.
()wwwwwwwwwwwww premium.
()xxxxxxxxxxxxx discount.
()yyyyyyyyyyyyy commission.
()zzzzzzzzzzzzz yield.
Answer:
()aaaaaaaaaaaaaa An option that can be exercised at any time up to maturity is called a(n)
()bbbbbbbbbbbbbb
swap.
()cccccccccccccc stock option.
()dddddddddddddd
European option.
()eeeeeeeeeeeeee American option.
Answer:
()ffffffffffffff
An option that can only be exercised at maturity is called a(n)
()gggggggggggggg
swap.
()hhhhhhhhhhhhhh
stock option.
()iiiiiiiiiiiiii
European option.
()jjjjjjjjjjjjjj
American option.
Answer:
()kkkkkkkkkkkkkk
Options on individual stocks are referred to as
()llllllllllllll
stock options.
()mmmmmmmmmmmmmm
futures options.
()nnnnnnnnnnnnnn
American options.
()oooooooooooooo
individual options.
Answer:
()pppppppppppppp
Options on futures contracts are referred to as
()qqqqqqqqqqqqqq
stock options.
()rrrrrrrrrrrrrr
futures options.
()ssssssssssssss American options.
()tttttttttttttt
individual options.
Answer:
()uuuuuuuuuuuuuu
An option that gives the owner the right to buy a financial instrument at
the exercise price within a specified period of time is a
()vvvvvvvvvvvvvv
call option.
()wwwwwwwwwwwwww
put option.
()xxxxxxxxxxxxxx
American option.
()yyyyyyyyyyyyyy
European option.
Answer:
()zzzzzzzzzzzzzz A call option gives the owner
()aaaaaaaaaaaaaaathe right to sell the underlying security.
()bbbbbbbbbbbbbbb
the obligation to sell the underlying security.
()cccccccccccccccthe right to buy the underlying security.
()ddddddddddddddd
the obligation to buy the underlying security.
Answer:
()eeeeeeeeeeeeeeeA call option gives the seller
()fffffffffffffff
the right to sell the underlying security.
()ggggggggggggggg
()hhhhhhhhhhhhhhh
the right to buy the underlying security.
()iiiiiiiiiiiiiii
Answer:
()jjjjjjjjjjjjjjj
An option allowing the holder to buy an asset in the future is a
()kkkkkkkkkkkkkkk
put option.
()lllllllllllllll
call option.
()mmmmmmmmmmmmmmm
swap.
()nnnnnnnnnnnnnnn
premium.
()ooooooooooooooo
forward contract.
Answer:
()ppppppppppppppp
An option that gives the owner the right to sell a financial instrument at
the exercise price within a specified period of time is a
()qqqqqqqqqqqqqqq
call option.
()rrrrrrrrrrrrrrr
put option.
()sssssssssssssss American option.
()ttttttttttttttt
European option.
Answer:
()uuuuuuuuuuuuuuu
A put option gives the owner
()vvvvvvvvvvvvvvv
()wwwwwwwwwwwwwww
()xxxxxxxxxxxxxxx
()yyyyyyyyyyyyyyy
Answer:
()zzzzzzzzzzzzzzzA put option gives the seller
()aaaaaaaaaaaaaaaa
()bbbbbbbbbbbbbbbb
()cccccccccccccccc
()dddddddddddddddd
Answer:
()eeeeeeeeeeeeeeee
An option allowing the owner to sell an asset at a future date is a
()ffffffffffffffff
put option.
()gggggggggggggggg
call option.
()hhhhhhhhhhhhhhhh
swap.
()iiiiiiiiiiiiiiii
forward contract.
()jjjjjjjjjjjjjjjj
futures contract.
Answer:
()kkkkkkkkkkkkkkkk
If you buy a call option on treasury futures at 115, and at expiration the
market price is 110,
()llllllllllllllll
the call will be exercised.
()mmmmmmmmmmmmmmmm the put will be exercised.
()nnnnnnnnnnnnnnnn
the call will not be exercised.
()oooooooooooooooo
the put will not be exercised.
Answer:
()pppppppppppppppp
If you buy a call option on treasury futures at 110, and at expiration the
()qqqqqqqqqqqqqqqq
()rrrrrrrrrrrrrrrr the put will be exercised.
()ssssssssssssssss the call will not be exercised.
()tttttttttttttttt
Answer:
()uuuuuuuuuuuuuuuu
If you buy a put option on treasury futures at 115, and at expiration the
()vvvvvvvvvvvvvvvv
()wwwwwwwwwwwwwwww
the put will be exercised.
()xxxxxxxxxxxxxxxx
()yyyyyyyyyyyyyyyy
Answer:
()zzzzzzzzzzzzzzzz
()aaaaaaaaaaaaaaaaa
()bbbbbbbbbbbbbbbbb
()ccccccccccccccccc
()ddddddddddddddddd
If you buy a put option on treasury futures at 110, and at expiration the
the put will be exercised.
Answer:
()eeeeeeeeeeeeeeeee
If, for a $1000 premium, you buy a $100,000 call option on bond futures
with a strike price of 110, and at the expiration date the price is 114
()fffffffffffffffff your profit is $4000.
()ggggggggggggggggg your loss is $4000.
()hhhhhhhhhhhhhhhhh your profit is $3000.
()iiiiiiiiiiiiiiiii
your loss is $3000.
()jjjjjjjjjjjjjjjjj
your loss is $1000.
Answer:
()kkkkkkkkkkkkkkkkk If, for a $1000 premium, you buy a $100,000 call option on bond futures
()lllllllllllllllll
()mmmmmmmmmmmmmmmmm
your loss is $4000.
()nnnnnnnnnnnnnnnnn your profit is $3000.
()ooooooooooooooooo your loss is $3000.
()ppppppppppppppppp your loss is $1000.
Answer:
()qqqqqqqqqqqqqqqqq If, for a $1000 premium, you buy a $100,000 put option on bond futures
()rrrrrrrrrrrrrrrrr your profit is $4000.
()sssssssssssssssssyour loss is $4000.
()ttttttttttttttttt
()uuuuuuuuuuuuuuuuu your loss is $3000.
()vvvvvvvvvvvvvvvvv your loss is $1000.
Answer:
()wwwwwwwwwwwwwwwww If, for a $1000 premium, you buy a $100,000 put option on bond
futures with a strike price of 114, and at the expiration date the price is 110
()xxxxxxxxxxxxxxxxx your profit is $4000.
()yyyyyyyyyyyyyyyyy
your loss is $4000.
()zzzzzzzzzzzzzzzzz
()aaaaaaaaaaaaaaaaaa
your loss is $3000.
()bbbbbbbbbbbbbbbbbb your loss is $1000.
Answer:
Figure 13-1
()cccccccccccccccccc
In figure 13-1, with a expiration price of 110, the best return is obtained
by
()dddddddddddddddddd buying futures.
()eeeeeeeeeeeeeeeeee
buying a call option.
()ffffffffffffffffff selling futures.
()gggggggggggggggggg buying a put option.
()hhhhhhhhhhhhhhhhhh none of the above.
Answer:
()iiiiiiiiiiiiiiiiii
In figure 13-1, with a expiration price of 120, the best return is obtained by
()jjjjjjjjjjjjjjjjjj
buying futures.
()kkkkkkkkkkkkkkkkkk buying a call option.
()llllllllllllllllll
selling futures.
()mmmmmmmmmmmmmmmmmm
buying a put option.
()nnnnnnnnnnnnnnnnnn none of the above.
Answer:
Figure 13-2
()oooooooooooooooooo In figure 13-2, with a expiration price of 110, the best return is obtained
by
()pppppppppppppppppp buying futures.
()qqqqqqqqqqqqqqqqqq buying a call option.
()rrrrrrrrrrrrrrrrrr selling futures.
()ssssssssssssssssss
buying a put option.
()tttttttttttttttttt
none of the above.
Answer:
()uuuuuuuuuuuuuuuuuu In figure 13-2, with a expiration price of 120, the best return is obtained
by
()vvvvvvvvvvvvvvvvvv buying futures.
()wwwwwwwwwwwwwwwwww buying a call option.
()xxxxxxxxxxxxxxxxxx selling futures.
()yyyyyyyyyyyyyyyyyy buying a put option.
()zzzzzzzzzzzzzzzzzz
none of the above.
Answer:
()aaaaaaaaaaaaaaaaaaa
The main advantage of using options on futures contracts rather than the
futures contracts themselves is that
()bbbbbbbbbbbbbbbbbbb interest rate risk is controlled while preserving the possibility of gains.
()ccccccccccccccccccc
interest rate risk is controlled, while removing the possibility of losses.
()ddddddddddddddddddd interest rate risk is not controlled, but the possibility of gains is preserved.
()eeeeeeeeeeeeeeeeeee
interest rate risk is not controlled, but the possibility of gains is lost.
Answer:
()fffffffffffffffffff The main reason to buy an option on a futures contract rather than the futures
contract is
()ggggggggggggggggggg to reduce transaction cost.
()hhhhhhhhhhhhhhhhhhh to preserve the possibility for gains.
()iiiiiiiiiiiiiiiiiii to limit losses.
()jjjjjjjjjjjjjjjjjjj remove the possibility for gains.
Answer:
()kkkkkkkkkkkkkkkkkkk The main disadvantage of hedging with futures contracts as compared to
options on futures contracts is that futures
()lllllllllllllllllll remove the possibility of gains.
()mmmmmmmmmmmmmmmmmmm
increase the transactions cost.
()nnnnnnnnnnnnnnnnnnn are not as an effective a hedge.
()ooooooooooooooooooo do not remove the possibility of losses.
Answer:
()ppppppppppppppppppp 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
()qqqqqqqqqqqqqqqqqqq buy put options on financial futures.
()rrrrrrrrrrrrrrrrrrr buy call options on financial futures.
()sssssssssssssssssss
sell put options on financial futures.
()ttttttttttttttttttt sell call options on financial futures.
Answer:
()uuuuuuuuuuuuuuuuuuu Hedging by buying an option
()vvvvvvvvvvvvvvvvvvv limits gains.
()wwwwwwwwwwwwwwwwwww
limits losses.
()xxxxxxxxxxxxxxxxxxx limits gains and losses.
()yyyyyyyyyyyyyyyyyyy has no limit on option premiums.
()zzzzzzzzzzzzzzzzzzz
has no limit on losses.
Answer:
()aaaaaaaaaaaaaaaaaaaa All other things held constant, premiums on options will increase when
the
()bbbbbbbbbbbbbbbbbbbb
exercise price increases.
()cccccccccccccccccccc volatility of the underlying asset falls.
()dddddddddddddddddddd
term to maturity increases.
()eeeeeeeeeeeeeeeeeeee (a) and (c) are both true.
Answer:
()ffffffffffffffffffff All other things held constant, premiums on call options will increase when the
()gggggggggggggggggggg
exercise price falls.
()hhhhhhhhhhhhhhhhhhhh
volatility of the underlying asset falls.
()iiiiiiiiiiiiiiiiiiii term to maturity decreases.
()jjjjjjjjjjjjjjjjjjjj futures price increases.
Answer:
()kkkkkkkkkkkkkkkkkkkk
An increase in the exercise price, all other things held constant,
will ______ the call option premium.
()llllllllllllllllllll increase
()mmmmmmmmmmmmmmmmmmmm decrease
()nnnnnnnnnnnnnnnnnnnn
increase or decrease
()oooooooooooooooooooo
Not enough information is given.
Answer:
()pppppppppppppppppppp
All other things held constant, premiums on options will increase
when the
()qqqqqqqqqqqqqqqqqqqq
exercise price increases.
()rrrrrrrrrrrrrrrrrrrr
volatility of the underlying asset increases.
()ssssssssssssssssssss
term to maturity decreases.
()tttttttttttttttttttt futures price increases.
Answer:
()uuuuuuuuuuuuuuuuuuuu
An increase in the volatility of the underlying asset, all other
things held constant, will ______ the option premium.
()vvvvvvvvvvvvvvvvvvvv
increase
()wwwwwwwwwwwwwwwwwwww
decrease
()xxxxxxxxxxxxxxxxxxxx
increase or decrease
()yyyyyyyyyyyyyyyyyyyy
Not enough information is given.
Answer:
()zzzzzzzzzzzzzzzzzzzz A tool for managing interest rate risk that requires exchange of payment
streams is a
()aaaaaaaaaaaaaaaaaaaaa futures contract.
()bbbbbbbbbbbbbbbbbbbbb
forward contract.
()ccccccccccccccccccccc swap.
()ddddddddddddddddddddd
micro hedge.
()eeeeeeeeeeeeeeeeeeeee macro hedge.
Answer:
()fffffffffffffffffffffA financial contract that obligates one party to exchange a set of payments it owns
for another set of payments owned by another party is called a
()ggggggggggggggggggggg
hedge.
()hhhhhhhhhhhhhhhhhhhhh
call option.
()iiiiiiiiiiiiiiiiiiiii put option.
()jjjjjjjjjjjjjjjjjjjjj swap.
Answer:
()kkkkkkkkkkkkkkkkkkkkk
A swap that involves the exchange of a set of payments in one
currency for a set of payments in another currency is a(n)
()lllllllllllllllllllll interest rate swap.
()mmmmmmmmmmmmmmmmmmmmm currency swap.
()nnnnnnnnnnnnnnnnnnnnn
swaptions.
()ooooooooooooooooooooo
national swap.
Answer:
()ppppppppppppppppppppp
A swap that involves the exchange of one set of interest payments
for another set of interest payments is called a(n)
()qqqqqqqqqqqqqqqqqqqqq
interest rate swap.
()rrrrrrrrrrrrrrrrrrrrr
currency swap.
()sssssssssssssssssssss
swaptions.
()ttttttttttttttttttttt national swap.
Answer:
()uuuuuuuuuuuuuuuuuuuuu
A firm that sells goods to foreign countries on a regular basis can
avoid exchange rate risk by
()vvvvvvvvvvvvvvvvvvvvv
buying stock options.
()wwwwwwwwwwwwwwwwwwwww selling puts on financial futures.
()xxxxxxxxxxxxxxxxxxxxx
selling a foreign exchange swap.
()yyyyyyyyyyyyyyyyyyyyy
buying swaptions.
Answer:
()zzzzzzzzzzzzzzzzzzzzz The most common type of interest rate swap is

()aaaaaaaaaaaaaaaaaaaaaa the plain vanilla swap.
()bbbbbbbbbbbbbbbbbbbbbb
the basic swap.
()cccccccccccccccccccccc the swaption.
()dddddddddddddddddddddd
the notional swap.
()eeeeeeeeeeeeeeeeeeeeee the ordinary swap.
Answer:
()ffffffffffffffffffffff
If Second National Bank has more rate-sensitive assets than rate-sensitive
liabilities, it can reduce interest rate risk with a swap that requires Second National to
()gggggggggggggggggggggg
pay fixed rate while receiving floating rate.
()hhhhhhhhhhhhhhhhhhhhhh
receive fixed rate while paying floating rate.
()iiiiiiiiiiiiiiiiiiiiii both receive and pay fixed rate.
()jjjjjjjjjjjjjjjjjjjjjj both receive and pay floating rate.
Answer:
()kkkkkkkkkkkkkkkkkkkkkk
If a bank has more rate-sensitive assets than rate-sensitive
liabilities
()llllllllllllllllllllll it reduces interest rate risk by swapping rate-sensitive income for fixed rate
income.
()mmmmmmmmmmmmmmmmmmmmmm
it reduces interest rate risk by swapping fixed rate
income for rate-sensitive income.
()nnnnnnnnnnnnnnnnnnnnnn
it increases interest rate risk by swapping rate-sensitive income
for fixed rate income.
()oooooooooooooooooooooo
it neutralizes interest rate risk by receiving and paying fixed-rate
streams.
()pppppppppppppppppppppp
it cannot reduce its interest rate risk.
Answer:
()qqqqqqqqqqqqqqqqqqqqqq
If Second National Bank has more rate-sensitive liabilities then
rate-sensitive assets, it can reduce interest rate risk with a swap that requires Second National to
()rrrrrrrrrrrrrrrrrrrrrr
pay fixed rate while receiving floating rate.
()ssssssssssssssssssssss receive fixed rate while paying floating rate.
()tttttttttttttttttttttt both receive and pay fixed rate.
()uuuuuuuuuuuuuuuuuuuuuu
both receive and pay floating rate.
Answer:
()vvvvvvvvvvvvvvvvvvvvvv
One advantage of using swaps to eliminate interest rate risk is
that swaps
()wwwwwwwwwwwwwwwwwwwwww are less costly than futures.
()xxxxxxxxxxxxxxxxxxxxxx
are less costly than rearranging balance sheets.
()yyyyyyyyyyyyyyyyyyyyyy
are more liquid than futures.
()zzzzzzzzzzzzzzzzzzzzzz have better accounting treatment than options.
Answer:
()aaaaaaaaaaaaaaaaaaaaaaa
A advantage of using swaps to hedge interest rate risk is that
swaps
()bbbbbbbbbbbbbbbbbbbbbbb
are less costly than futures.
()ccccccccccccccccccccccc
can be written for long horizons.
()ddddddddddddddddddddddd
are not subject to default risk.
()eeeeeeeeeeeeeeeeeeeeeee
are more liquid than futures.
()fffffffffffffffffffffff
have better accounting treatment than options.
Answer:
()ggggggggggggggggggggggg
The disadvantage of swaps is that they
()hhhhhhhhhhhhhhhhhhhhhhh
lack liquidity.
()iiiiiiiiiiiiiiiiiiiiiii are difficult to arrange for a counterparty.
()jjjjjjjjjjjjjjjjjjjjjjj suffer from default risk.
()kkkkkkkkkkkkkkkkkkkkkkk
all of the above.
Answer:
()lllllllllllllllllllllll A disadvantage of using swaps to control interest rate risk is that
()mmmmmmmmmmmmmmmmmmmmmmm
swaps cannot be written for long horizons.
()nnnnnnnnnnnnnnnnnnnnnnn
swaps are more expensive than restructuring balance sheets.
()ooooooooooooooooooooooo
swaps, like forward contracts, lack liquidity.
()ppppppppppppppppppppppp
all of the above are disadvantages of swaps.
()qqqqqqqqqqqqqqqqqqqqqqq
only (a) and (b) of the above are disadvantages of swaps.
Answer:
()rrrrrrrrrrrrrrrrrrrrrrr
The problems of default risk and finding counterparties for interest rate
swaps has been reduced by
()sssssssssssssssssssssss government regulation.
()ttttttttttttttttttttttt writing complex contracts.
()uuuuuuuuuuuuuuuuuuuuuuu
commercial and investment banks serving as intermediaries.
()vvvvvvvvvvvvvvvvvvvvvvv
all of the above.
()wwwwwwwwwwwwwwwwwwwwwww
both (b) and (c) of the above.
Answer:
)2
Essay Questions
()a
What is arbitrage? Explain why arbitrage drives the contract price of futures to the price of
the underlying asset on the expiration date, for prices above and below the asset price.
()b
Explain the margin requirement for financial futures and how marking to market affects the
margin account.
()c
Show graphically and explain the profits and losses of buying futures relative to buying call
options.

Financial Derivatives Explained

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186Frederic S.

MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

The payoffs for financial derivatives are linked to

Financial derivatives include

Which of the following is not a financial derivative?

187Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives188

A person who agrees to buy an asset at a future date has gone

189Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

To say that the forward market lacks liquidity means that

A disadvantage of a forward contract is that

The advantage of forward contracts over future contracts is that they

Chapter 13Financial Derivatives190

()yyyy Forward contracts are of limited usefulness to financial institutions because

191Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives192

Elimination of riskless profit opportunities in the futures market is

193Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives194

195Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives196

197Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives198

199Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives200

201Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives202

203Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives204

205Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives206

207Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

Chapter 13Financial Derivatives208

()zzzzzzzzzzzzzzzzzzzzz The most common type of interest rate swap is

209Frederic S. MishkinEconomics of Money, Banking, and Financial Markets, Seventh Edition

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