Chapter 25 - Derivatives and Hedging Risk

45. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. You then decide to reverse your
position in the futures market on the fifth day at close. What is the net amount you receive at
the end of 5 days?
A. $0.00
B. $2.60
C. $2.70
D. $2.80
E. Must know the number of contracts

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

Difficulty level: Medium

Topic: FUTURES AND PROCEEDS
Type: PROBLEMS

46. You have taken a short position in a futures contract on corn at $2.60 per bushel. Over the
next 5 days the contract settled at 2.52, 2.57, 2.62, 2.68, 2.70. Before you can reverse your
position in the futures market on the fifth day you are notified to complete delivery. What will
you receive on delivery and what is the net amount you receive in total?
A. $2.60; $-0.10
B. $2.60; $0.10
C. $2.60; $2.70
D. $2.70; $-0.10
E. $2.70; $2.60

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

Difficulty level: Medium

Topic: FUTURES AND PROCEEDS
Type: PROBLEMS

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47. You bought a futures contract for $2.60 per bushel and the contract ended at $2.70 after
several days of trading with the following close prices each day: $2.52, $2.57, $2.62, $2.68,
and $2.70. What would the mark to market sequence be?
A. -.08, .05, .05, .06, .02
B. .08, -.05, -.05, -.06, -.02
C. .08, .03, -.02, -.06, -.10
D. -.08, -.03, .02, .06, .10
E. .10, .06, .02, -.03, -.08

Daily marking to the market from prior day settle.

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

Difficulty level: Medium

Topic: MARK TO MARKET
Type: PROBLEMS

48. Suppose you agree to purchase one ounce of gold for $382 any time over the next month.
The current price of gold is $380. The spot price of gold then falls to $377 the next day. If the
agreement is represented by a futures contract marking to market on a daily basis as the price
changes, what is your cash flow at the end of the next business day?
A. $0
B. $3
C. $5
D. $-3
E. $-5

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

Difficulty level: Medium

Topic: FUTURES AND CASH FLOW
Type: PROBLEMS

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Chapter 25 - Derivatives and Hedging Risk

49. On March 1, you contract to take delivery of 1 ounce of gold for $415. The agreement is
good for any day up to April 1. Throughout March, the price of gold hit a low of $385 and hit
a high of $435. The price settled on March 31 at $420, and on April 1st you settle your futures
agreement at that price. Your net cash flow is:
A. $-30.
B. $-20.
C. $-15.
D. $5.
E. $20.

NCF = $420 - $415 = $5

Difficulty level: Medium

Topic: FUTURES AND CASH FLOW
Type: PROBLEMS

50. A bank has a $50 million mortgage bond risk position which it hedges in the Treasury
bond futures markets at the Chicago Board of Trade. Approximately how many contracts are
needed to be held in the hedge?
A. 5
B. 50
C. 500
D. 5,000
E. 50,000

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

Difficulty level: Easy

Topic: FUTURES CONTRACTS
Type: PROBLEMS

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Chapter 25 - Derivatives and Hedging Risk

51. A mortgage banker had made loan commitments for $10 million in 3 months. How many
contracts on Treasury bonds futures must the banker write or buy?
A. Go short 10.
B. Go short 100.
C. Go long 10.
D. Go long 100.
E. None of the above.

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

Difficulty level: Medium

Topic: TREASURY BOND FUTURES
Type: PROBLEMS

52. The duration of a 2 year annual 10% bond that is selling for par is:
A. 1.00 years.
B. 1.91 years.
C. 2.00 years.
D. 2.09 years.
E. None of the above.

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

Difficulty level: Medium

Topic: DURATION
Type: PROBLEMS

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Chapter 25 - Derivatives and Hedging Risk

53. Firm A is paying $750,000 in interest payments a year while Firm B is paying LIBOR
plus 75 basis points on $10,000,000 loans. The current LIBOR rate is 6.5%. Firm A and B
have agreed to swap interest payments. What is the net payment this year?
A. Firm A pays $750,000 to Firm B
B. Firm B pays $725,000 to Firm A
C. Firm B pays $25,000 to Firm A
D. Firm A pays $25,000 to Firm B
E. None of the above.

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

Difficulty level: Medium

Topic: SWAPS
Type: PROBLEMS

54. A Treasury note with a maturity of 2 years pays interest semi-annually on a 9 percent
annual coupon rate. The $1,000 face value is returned at maturity. If the effective annual yield
for all maturities is 7 percent annually, what is the current price of the Treasury note?
A. $960.68
B. $986.69
C. $1,010.35
D. $1,034.40
E. $1,038.99

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

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

Difficulty level: Medium

Topic: NOTE PRICE
Type: PROBLEMS

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Chapter 25 - Derivatives and Hedging Risk

55. Calculate the duration of a 7-year $1,000 zero-coupon bond with a current price of
$399.63 and a yield to maturity of 14%.
A. 5 years
B. 6 years
C. 7 years
D. 8 years
E. 9 years

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

Difficulty level: Medium

Topic: DURATION
Type: PROBLEMS

56. Calculate the duration of a 4-year $1,000 face value bond, which pays 8% coupons
annually throughout maturity and has a yield to maturity of 9%.
A. 3.29 years
B. 3.57 years
C. 3.69 years
D. 3.89 years
E. 4.00 years

D = [80/(1.09 + 160)/(1.09)2+ 240/(1.09)3+ 4,320/(1.09)4]/967.60 = 3453.78/967.60 = 3.569

years.

Difficulty level: Medium

Topic: DURATION
Type: PROBLEMS

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Chapter 25 - Derivatives and Hedging Risk

57. On March 1, you contract to take delivery of 1 ounce of gold for $495. The agreement is
good for any day up to April 1. Throughout March, the price of gold hit a low of $425 and hit
a high of $535. The price settled on March 31 at $505, and on April 1st you settle your futures
agreement at that price. Your net cash flow is:
A. $-30.
B. $-20.
C. $-15.
D. $10.
E. $20.

NCF = $505 - $495 = $10

Difficulty level: Medium

Topic: FUTURES AND CASH FLOW
Type: PROBLEMS

58. A bank has a $80 million mortgage bond risk position which it hedges in the Treasury
bond futures markets at the Chicago Board of Trade. Approximately how many contracts are
needed to be held in the hedge?
A. 5
B. 80
C. 800
D. 8,000
E. 80,000

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

Difficulty level: Easy

Topic: FUTURES CONTRACTS
Type: PROBLEMS

Essay Questions

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Chapter 25 - Derivatives and Hedging Risk

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

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

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

Topic: DURATION
Type: ESSAYS

60. What new asset duration will immunize the balance sheet?

Given DL = 1.111(see #55 above), then DA 39 = 1.111(36); DA = 1.0255 years

Topic: DURATION
Type: ESSAYS

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Chapter 25 - Derivatives and Hedging Risk

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

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

Topic: DURATION
Type: ESSAYS

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

There are several reasons:

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

Topic: FUTURES MARKETS

Type: ESSAYS

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