Financial Derivatives

Multiple Choice Questions

1) The payoffs for financial derivatives are linked to
(a) securities that will be issued in the future.
(b) the volatility of interest rates.
(c) previously issued securities.
(d) government regulations specifying allowable rates of return.
(e) none of the above.
Answer: C

2) Financial derivatives include

(a) stocks.
(b) bonds.
(c) futures.
(d) none of the above.
Answer: C

3) Financial derivatives include

(a) stocks.
(b) bonds.
(c) forward contracts.
(d) both (a) and (b) are true.
Answer: C

4) Which of the following is not a financial derivative?

(a) Stock
(b) Futures
(c) Options
(d) Forward contracts
Answer: A
5) By hedging a portfolio, a bank manager
(a) reduces interest rate risk.
(b) increases reinvestment risk.
(c) increases exchange rate risk.
(d) increases the probability of gains.
Answer: A

6) Which of the following is a reason to hedge a portfolio?

(a) To increase the probability of gains.
(b) To limit exposure to risk.
(c) To profit from capital gains when interest rates fall.
(d) All of the above.
(e) Both (a) and (c) of the above.
Answer: B

7) Hedging risk for a long position is accomplished by

(a) taking another long position.
(b) taking a short position.
(c) taking additional long and short positions in equal amounts.
(d) taking a neutral position.
(e) none of the above.
Answer: B

8) Hedging risk for a short position is accomplished by

(a) taking a long position.
(b) taking another short position.
(c) taking additional long and short positions in equal amounts.
(d) taking a neutral position.
(e) none of the above.
Answer: A

9) A contract that requires the investor to buy securities on a future date is called a
(a) short contract.
(b) long contract.
(c) hedge.
(d) cross.
Answer: B
10) A long contract requires that the investor
(a) sell securities in the future.
(b) buy securities in the future.
(c) hedge in the future.
(d) close out his position in the future.
Answer: B

11) A person who agrees to buy an asset at a future date has gone
(a) long.
(b) short.
(c) back.
(d) ahead.
(e) even.
Answer: A

12) A short contract requires that the investor

(a) sell securities in the future.
(b) buy securities in the future.
(c) hedge in the future.
(d) close out his position in the future.
Answer: A

13) A contract that requires the investor to sell securities on a future date is called a
(a) short contract.
(b) long contract.
(c) hedge.
(d) micro hedge.
Answer: A

14) If a bank manager chooses to hedge his portfolio of treasury securities by selling futures contracts, he
(a) gives up the opportunity for gains.
(b) removes the chance of loss.
(c) increases the probability of a gain.
(d) both (a) and (b) are true.
Answer: D
15) To say that the forward market lacks liquidity means that
(a) forward contracts usually result in losses.
(b) forward contracts cannot be turned into cash.
(c) it may be difficult to make the transaction.
(d) forward contracts cannot be sold for cash.
(e) none of the above.
Answer: C

16) A disadvantage of a forward contract is that

(a) it may be difficult to locate a counterparty.
(b) the forward market suffers from lack of liquidity.
(c) these contracts have default risk.
(d) all of the above.
(e) both (a) and (c) of the above.
Answer: D

17) Forward contracts are risky because they

(a) are subject to lack of liquidity
(b) are subject to default risk.
(c) hedge a portfolio.
(d) both (a) and (b) are true.
Answer: D

18) The advantage of forward contracts over future contracts is that they
(a) are standardized.
(b) have lower default risk.
(c) are more liquid.
(d) none of the above.
Answer: D

19) The advantage of forward contracts over futures contracts is that they
(a) are standardized.
(b) have lower default risk.
(c) are more flexible.
(d) both (a) and (b) are true.
Answer: C
20) Forward contracts are of limited usefulness to financial institutions because
(a) of default risk.
(b) it is impossible to hedge risk.
(c) of lack of liquidity.
(d) all of the above.
(e) both (a) and (c) of the above.
Answer: E

21) Futures contracts are regularly traded on the

(a) Chicago Board of Trade.
(b) New York Stock Exchange.
(c) American Stock Exchange.
(d) Chicago Board of Options Exchange.
Answer: A

22) Hedging in the futures market

(a) eliminates the opportunity for gains.
(b) eliminates the opportunity for losses.
(c) increases the earnings potential of the portfolio.
(d) does all of the above.
(e) does both (a) and (b) of the above.
Answer: E

23) When interest rates fall, a bank that perfectly hedges its portfolio of Treasury securities in the
futures market
(a) suffers a loss.
(b) experiences a gain.
(c) has no change in its income.
(d) none of the above.
Answer: C

24) Futures markets have grown rapidly because futures

(a) are standardized.
(b) have lower default risk.
(c) are liquid.
(d) all of the above.
Answer: D
25) Parties who have bought a futures contract and thereby agreed to (take delivery of) the bonds
are said to have taken a position.
(a) sell; short
(b) buy; short
(c) sell; long
(d) buy; long
Answer: D

26) Parties who have sold a futures contract and thereby agreed to (deliver) the bonds are said to
have taken a position.
(a) sell; short
(b) buy; short
(c) sell; long
(d) buy; long
Answer: A

27) By selling short a futures contract of $100,000 at a price of 115 you are agreeing to deliver
(a) $100,000 face value securities for $115,000.
(b) $115,000 face value securities for $110,000.
(c) $100,000 face value securities for $100,000.
(d) $115,000 face value securities for $115,000.
Answer: A

28) By selling short a futures contract of $100,000 at a price of 96 you are agreeing to deliver
(a) $100,000 face value securities for $104,167.
(b) $96,000 face value securities for $100,000.
(c) $100,000 face value securities for $96,000.
(d) $96,000 face value securities for $104,167.
Answer: C

29) By buying a long $100,000 futures contract for 115 you agree to pay
(a) $100,000 for $115,000 face value bonds.
(b) $115,000 for $100,000 face value bonds.
(c) $86,956 for $100,000 face value bonds.
(d) $86,956 for $115,000 face value bonds.
Answer: B
30) On the expiration date of a futures contract, the price of the contract
(a) always equals the purchase price of the contract.
(b) always equals the average price over the life of the contract.
(c) always equals the price of the underlying asset.
(d) always equals the average of the purchase price and the price of underlying asset.
(e) cannot be determined.
Answer: C

31) The price of a futures contract at the expiration date of the contract
(a) equals the price of the underlying asset.
(b) equals the price of the counterparty.
(c) equals the hedge position.
(d) equals the value of the hedged asset.
(e) none of the above.
Answer: A

32) Elimination of riskless profit opportunities in the futures market is

(a) hedging.
(b) arbitrage.
(c) speculation.
(d) underwriting.
(e) diversification.
Answer: B

33) 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
(a) your profit is $4000.
(b) your loss is $4000.
(c) your profit is $6000.
(d) your loss is $6000.
(e) your profit is $10,000.
Answer: B

34) 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
(a) your profit is $3000.
(b) your loss is $3000.
(c) your profit is $8000.
(d) your loss is $8000.
(e) your profit is $5000.
Answer: A
35) 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
(a) your profit is $4000.
(b) your loss is $4000.
(c) your profit is $6000.
(d) your loss is $6000.
(e) your profit is $10,000.
Answer: A

36) 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
(a) your profit is $3000.
(b) your loss is $3000.
(c) your profit is $8000.
(d) your loss is $8000.
(e) your profit is $5000.
Answer: B

37) If you sold a short contract on financial futures you hope interest rates
(a) rise.
(b) fall.
(c) are stable.
(d) fluctuate.
Answer: A

38) If you sold a short futures contract you will hope that interest rates
(a) rise.
(b) fall.
(c) are stable.
(d) fluctuate.
Answer: A

39) If you bought a long contract on financial futures you hope that interest rates
(a) rise.
(b) fall.
(c) are stable.
(d) fluctuate.
Answer: B
40) If you bought a long futures contract you hope that bond prices
(a) rise.
(b) fall.
(c) are stable.
(d) fluctuate.
Answer: A

41) If you sold a short futures contract you will hope that bond prices
(a) rise.
(b) fall.
(c) are stable.
(d) fluctuate.
Answer: B

42) To hedge the interest rate risk on $4 million of Treasury bonds with $100,000 futures contracts, you
would need to purchase
(a) 4 contracts.
(b) 20 contracts.
(c) 25 contracts.
(d) 40 contracts.
(e) 400 contracts.
Answer: D

43) 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
(a) $250,000.
(b) $1,000,000.
(c) $2,500,000.
(d) $5,000,000.
(e) $25,000,000.
Answer: C

44) Assume you are holding Treasury securities and have sold futures to hedge against interest rate risk.
If interest rates rise
(a) the increase in the value of the securities equals the decrease in the value of the futures contracts.
(b) the decrease in the value of the securities equals the increase in the value of the
futures contracts.
(c) the increase in the value of the securities exceeds the decrease in the values of the futures
contracts.
(d) both the securities and the futures contracts increase in value.
(e) both the securities and the futures contracts decrease in
value Answer: B
45) Assume you are holding Treasury securities and have sold futures to hedge against interest rate risk.
If interest rates fall
(a) the increase in the value of the securities equals the decrease in the value of the futures contracts.
(b) the decrease in the value of the securities equals the increase in the value of the
futures contracts.
(c) the increase in the value of the securities exceeds the decrease in the values of the
futures contracts.
(d) both the securities and the futures contracts increase in value.
(e) both the securities and the futures contracts decrease in
value. Answer: A

46) When a financial institution hedges the interest-rate risk for a specific asset, the hedge is called a
(a) macro hedge.
(b) micro hedge.
(c) cross hedge.
(d) futures hedge.
Answer: B

47) When the financial institution is hedging interest-rate risk on its overall portfolio, then the hedge is a
(a) macro hedge.
(b) micro hedge.
(c) cross hedge.
(d) futures hedge.
Answer: A

48) The number of futures contracts outstanding is called

(a) liquidity.
(b) volume.
(c) float.
(d) open interest.
(e) turnover.
Answer: D

49) Which of the following features of futures contracts were not designed to increase liquidity?
(a) Standardized contracts
(b) Traded up until maturity
(c) Not tied to one specific type of bond
(d) Marked to market daily
Answer: D
50) Which of the following features of futures contracts were not designed to increase liquidity?
(a) Standardized contracts
(b) Traded up until maturity
(c) Not tied to one specific type of bond
(d) Can be closed with offsetting trade
Answer: D