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CHAPTER 23

DERIVATIVES AND RISK MANAGEMENT


Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.

True/False

Easy:
(23.1) Risk management FP Answer: a EASY
1
. One objective of risk management can be to reduce the volatility of a
firms cash flows.

a. True
b. False

(23.4) Swaps FP Answer: b EASY


2
. Interest rate swaps allow a firm to exchange fixed for floating-rate
payments, but a swap cannot reduce actual net interest expenses.

a. True
b. False

(23.5) Speculative versus pure risk FP Answer: a EASY


3
. Speculative risks are symmetrical in the sense that they offer the
chance of a gain as well as a loss, while pure risks are those that can
only lead to losses.

a. True
b. False

(23.6) Risk management FP Answer: b EASY


4
. In theory, reducing the volatility of its cash flows will always
increase a companys value.

a. True
b. False

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to a publicly accessible website, in whole or in part.

Chapter 23: Derivatives True/False Page 1


Medium:
(23.6) Futures market hedging FP Answer: b MEDIUM
5
. The two basic types of hedges involving the futures market are long
hedges and short hedges, where the words "long" and "short" refer to the
maturity of the hedging instrument. For example, a long hedge might use
Treasury bonds, while a short hedge might use 3-month T-bills.

a. True
b. False

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to a publicly accessible website, in whole or in part.

Page 2 True/False Chapter 23: Derivatives


Multiple Choice: Conceptual

Medium:
(23.1) Risk management CP Answer: e MEDIUM
6
. Which of the following are NOT ways risk management can be used to
increase the value of a firm?

a. Risk management can increase debt capacity.


b. Risk management can help a firm maintain its optimal capital budget.
c. Risk management can reduce the expected costs of financial distress.
d. Risk management can help firms minimize taxes.
e. Risk management can allow managers to defer receipt of their bonuses
and thus postpone tax payments.

(23.1) Interest rate and reinvestment rate risk CP Answer: b MEDIUM


7
. Which of the following statements about interest rate and reinvestment
rate risk is CORRECT?

a. Variable (or floating) rate securities have more interest rate


(price) risk than fixed rate securities.
b. Interest rate price risk exists because fixed-rate debt securities
lose value when interest rates rise, while reinvestment rate risk is
the risk of earning less than expected when interest payments or debt
principal are reinvested.
c. Interest rate price risk can be eliminated by holding zero coupon
bonds.
d. Reinvestment rate risk can be eliminated by holding variable (or
floating) rate bonds.
e. Interest rate risk can never be reduced.

(23.4) Swaps CP Answer: d MEDIUM


8
. A swap is a method used to reduce financial risk. Which of the
following statements about swaps, if any, is NOT CORRECT?

a. A swap involves the exchange of cash payment obligations.


b. The earliest swaps were currency swaps, in which companies traded
debt denominated in different currencies, say dollars and pounds.
c. Swaps are very often arranged by a financial intermediary, who may or
may not take the position of one of the counterparties.
d. A problem with swaps is that no standardized contracts exist, which
has prevented the development of a secondary market.
e. A company can swap fixed interest payments for floating interest
payments.

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.

Chapter 23: Derivatives Conceptual Questions Page 3


(23.4) Forwards vs. futures CP Answer: b MEDIUM
9
. Which of the following statements is most CORRECT?

a. One advantage of forward contracts is that they are default free.


b. Futures contracts generally trade on an organized exchange and are
marked to market daily.
c. Goods are never delivered under forward contracts, but are almost
always delivered under futures contracts.
d. There are futures contracts for currencies but no forward contracts
for currencies.
e. Futures contracts dont have any margin requirements but forward
contracts do.

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.

Page 4 Conceptual Questions Chapter 23: Derivatives


(23.6) Hedging CP Answer: d MEDIUM
10
. A commercial bank recognizes that its net income suffers whenever
interest rates increase. Which of the following strategies would
protect the bank against rising interest rates?

a. Buying inverse floaters.


b. Entering into an interest rate swap where the bank receives a fixed
payment stream, and in return agrees to make payments that float with
market interest rates.
c. Purchase principal only (PO) strips that decline in value whenever
interest rates rise.
d. Enter into a short hedge where the bank agrees to sell interest rate
futures.
e. Sell some of the banks floating-rate loans and use the proceeds to
make fixed-rate loans.

Multiple Choice: Problems

Medium:
(23.4) Swapsnonalgorithmic CP Answer: b MEDIUM
11
. Company A can issue floating-rate debt at LIBOR + 1%, and it can issue
fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR
+ 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issues
floating-rate debt and B issues fixed-rate debt, after which they engage
in the following swap: A will make a fixed 7.95% payment to B, and B
will make a floating-rate payment equal to LIBOR to A. What are the
resulting net payments of A and B?

a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%.


b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%.
c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%.
d. A pays a fixed rate of 7.95%, B pays LIBOR.
e. None of the above answers is correct.

(23.6) Treasury bond futures contracts CP Answer: c MEDIUM


12
. Suppose the September CBOT Treasury bond futures contract has a quoted
price of 89-09. What is the implied annual interest rate inherent in
this futures contract?

a. 6.32%
b. 6.65%
c. 7.00%
d. 7.35%
e. 7.72%

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.

Chapter 23: Derivatives Problems Page 5


(23.6) Treasury bond futures contracts CP Answer: d MEDIUM
13
. Suppose the December CBOT Treasury bond futures contract has a quoted
price of 80-07. What is the implied annual interest rate inherent in
the futures contract?

a. 6.86%
b. 7.22%
c. 7.60%
d. 8.00%
e. 8.40%

(23.6) Treasury bond futures contracts CP Answer: a MEDIUM


14
. Suppose the December CBOT Treasury bond futures contract has a quoted
price of 80-07. If annual interest rates go up by 1.00 percentage
point, what is the gain or loss on the futures contract? (Assume a
$1,000 par value, and round to the nearest whole dollar.)

a. -$78.00
b. -$82.00
c. -$86.00
d. -$90.00
e. -$95.00

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.

Page 6 Problems Chapter 23: Derivatives


CHAPTER 23
ANSWERS AND SOLUTIONS

2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part.

Chapter 23: Derivatives Answers Page 7


1 . (23.1) Risk management FP Answer: a EASY

2. (23.4) Swaps FP Answer: b EASY

3. (23.5) Speculative versus pure risk FP Answer: a EASY

4. (23.6) Risk management FP Answer: b EASY

5. (23.6) Futures market hedging FP Answer: b MEDIUM

6 . (23.1) Risk management CP Answer: e MEDIUM

7. (23.1) Interest rate and reinvestment rate risk CP Answer: b MEDIUM

8. (23.4) Swaps CP Answer: d MEDIUM

9. (23.4) Forwards vs. futures CP Answer: b MEDIUM

10. (23.6) Hedging CP Answer: d MEDIUM

Given its interest rate exposure, the bank needs a strategy which is profitable whenever interest rates rise. If
designed correctly, the profits from this strategy can partially, or in some cases, completely offset the losses the
bank realizes from its basic operations whenever rates rise. Of the 5 strategies, only the short hedge is profitable
when rates rise--all the other strategies would make sense if the bank were looking for extra profits when rates
dropped.

11. (23.4) Swapsnonalgorithmic CP Answer: b MEDIUM

A pays LIBOR + 1% to its lenders, receives LIBOR from B, and pays B 7.95%, for a net fixed payment of 8.95%.
B pays 9.4% to its lenders, pays LIBOR to A, and receives 7.95% from A, for a net payment of LIBOR + 1.45%.

12. (23.6) Treasury bond futures contracts CP Answer: c MEDIUM

Quote: 89-09 0.89 0.09

N: 40
PV = (0.89 + .09/32) $1,000 = -$892.8125
FV = $1,000
PMT = $30
I/YR = 3.50%

Annual rate: I/YR 2 = 7.00%

13. (23.6) Treasury bond futures contracts CP Answer: d MEDIUM

Quote: 80-07 0.80 0.07

N: 40
PV = (0.80+0.07/32) $1,000 = -$802.1875
FV = $1,000
PMT = $30
I/YR = 4.00%

Annual rate: I/YR 2 = 8.00%

14. (23.6) Treasury bond futures contracts CP Answer: a MEDIUM

Quote: 80-07 0.80 0.07


Increase in annual rate: 0.01000
Par value: $1,000
N: 40
PMT: $30
Price = PV = (0.80+0.07/32) $1,000 = -$802.1875

Enter data to get rate = I/YR 2 = 7.9986%


New rate = (Old rate + 1.0%)/2 = 4.4993%
New price = -$724.08
Change in price = loss = -$78

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