MULTIPLE-CHOICE QUESTIONS

NB: Mark your answers on the computerised sheet provided

1. The three-month interest rates in Switzerland and the United States are 9% and 3% per
annum respectively, with continuous compounding. The spot price of the Swiss franc is
USD0.75. What is the three-month forward exchange rate (to four decimal places)?

A: 0.7613
B: 0.7388*
C: 0.7636
D: None of the above

The US is the 'domestic' country since the exchange rate is USD/CHF]

Therefore, r = 3% and rf =9%

(r −r )T
Applying F =S e f
0 0
F0 = 0.7500e(0.03 - 0.09) * 0.25
F0 = 0.7388

2. An investor receives $1,150 after investing $1,000 for one year. What is the
percentage return per annum with monthly compounding (rounded to two decimal
places)?

A: 15.04%
B: 14.09%
C: 14.06%*
D: 15.01%

R mn
A(1+ m)
1150 = 1000( 1 + r/12)12
Solve for r

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3. An investor receives $1245 after investing $1000 for one year. What is the percentage
return per annum with continuous compounding (rounded to two decimal places)?

A: 25.43%
B: 21.91%*
C: 22.21%
D: None of the above

1245 = 1000er
1.245 = er
ln 1.245 = r
r = 21.91

4. On March 1 the price of oil is $50 and the July futures price is $48. On June 1 the
price of oil is $60 and the July futures price is $57.50. A company entered into a futures
contract on March 1 to hedge the purchase of oil on June 1. It closed out its position on
June 1. What is the effective price paid by the company for oil?

A: $50.00
B: $56.50
C: $50.50*
D: None of the above

You buy oil in the futures market. The futures price rises from $48 to $57.50, a profit of
$9.50. This is subtracted from the spot price on June 1 ($60 - $9.50) to get the effective
price of $50.50

5. Assume the same values as in question 4. What is the effective price received if a
company enters into a futures contract to hedge the sale of oil on June 1 and also
closes out on June 1?

A: $57.50
B: $43.50
C: $51.50
D: None of the above.*

The company takes out a contract to sell oil at $48. The futures price is $57.50 on June 1,
therefore a loss of $48 minus $57.50 is made in the futures market. This is subtracted
from the June 1 spot price to give an effective price received of $50.50, therefore D is
correct.

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6. The three-year zero rate is 7% and the four-year zero rate is 7.5% (both continuously
compounded). What is the forward rate for the fourth year?

A: 8%
B: 9% *
C: 8.5%
D: There is insufficient information to calculate the year 4 forward rate.

R2T2 − R1T1
Rf =
T2 − T1
(7.5*4) - (7*3)/4-3 = 9%

7. A company enters into a short futures contract to sell 75,000 pounds of cotton for 85
cents per pound. The initial margin is $8,000 and the maintenance margin is $6,000.
What price of cotton futures (to the nearest cent) will trigger a margin call?

A: 90 cents
B: 77 cents
C: 88 cents*
D: None of the above

The total value of the position is 75,000*85 cents = $63750

The price would have to rise so that the total value of the position was $63750 + $2000 =
$65750. (The margin account will have to fall from $8000 to $6000).
We can now solve for the price that gives this total value:
75000*P = $65750
P = 0.8766 = 87.67 cents = 88 cents (rounded)

8. An investor has a shareholding worth AUD 5m. The Beta of the portfolio is 2. The
investor decides to hedge the shareholding by taking a position in the share index
futures market. The relevant index is currently at 1000 and contracts are worth $200

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 times the index. What position should the investor take to hedge the portfolio and at
the same time, change the Beta of the portfolio to 1?

A: Buy 50 contracts
B: Sell 25 contracts*
C: Buy 25 contracts
D: Sell 50 contracts

Applying N* = Beta (P/A)

2 (5,000,000/200*1000) = 2(25) = 50
This figure tells us that we must sell 50 contracts to reduce Beta from 2 to 0, therefore if
we sell 25 contracts we reduce Beta from 2 to 1.

9. An investor is in the same situation as in the previous question, but wants to increase
the Beta of the portfolio to 3. What position should the investor take in the futures
market?

A: Buy 25 contracts*
B: Sell 25 contracts
C: Buy 50 contracts
D: Sell 100 contracts

If we must sell 50 contracts to reduce Beta from 2 to 0, we must buy 25 contracts to

increase Beta from 2 to 3.

10. The risk-free rate of interest is 9% per annum with continuous compounding, and
the dividend yield on a stock index is 2.5% per annum. The current value of the index is
2300. What is the 3-month futures price (rounded to the nearest whole index number)?

A: 2337
B: 2431
C: 2789
D: 2338*

Apply F0 = S0 e(r–q )T Forward price with known yield

(0.09 - 0.025)*0.25
F0 = 2300e = 2338 rounded

11. A stock is expected to pay a dividend of $3 per share in one month and 4 months.
The current stock price is $100 and the risk free rate is 5% p.a. for all maturities with
continuous compounding. What is the six-month forward price?

A: $103.32
B: $96.44*
C: $97.65

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D: None of the above

F0 = (S0 - I)erT
I = 3e-0.05*1/12 + 3e-0.05 * 4/12 = 5.9397
F0 = (100 - 5.9379)e 0.05*0.5
F0 = $96.44

12. A holder of a share portfolio with a beta of 1.75 uses share index futures to reduce
the beta of the portfolio to 1. This means that the portfolio will provide a return
approximately equal to

A: The risk free rate

B: The market portfolio*
C: The dividend yield
D: None of the above

Definition of beta (see Lecture 5)

13. The achievement of a perfect hedge means that the hedger is effectively paying

A: The futures price at the expiry of the contract

B: The spot price at the inception of the contract
C: The futures price at the inception of the contract*
D: The spot price at the expiry of the contract

See Lecture 5 for discussion of basis risk etc.

14. A long forward contract that was negotiated some time ago will expire in three
months and has a delivery price of $45. The current forward price for the three-month
contract is $43. The risk-free interest rate (with continuous compounding) is 7% p.a.
What is the value of the long forward contract (to the nearest cent)?

A: -$1.93
B: -$1.94
C: $2.03
D: None of the above*
-rT
f = (F0 – K)e
f = (43 - 45)e-0.07*3/12
f= -$1.96 , therefore D is correct

15. Suppose that the standard deviation of monthly changes in the price of a commodity
is $4. The standard deviation of monthly changes on futures prices for a contract on
commodity B (which is similar to commodity A) is $8. The correlation between the

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futures price and the commodity price is 0.75. What hedge ratio should be used when
hedging a one-month exposure to the price of commodity A?

A: 0.75
B: 0.375*
C. 1.75
D: 2

σS
h=ρ
σF

h = 0.75(4/8)
h = 0.375

16. Which of the following explains basis risk

A: The asset whose price is being hedged may not be exactly the same as the asset
underlying the futures contract
B: The transaction date in the physical market may be uncertain
C: The futures position may be closed out before the expiration date.
D: All of the above*

A,B, & C are all reasons for the existence of basis risk.

17. On March 1 the price of gold is $300 and the December futures price is $315. On
November 1 the price of gold is $280 and the December futures price is $281. A gold
producer entered into a December futures contract on March 1 to hedge the sale of gold
on November 1. What is the effective price received by the producer for the gold?

A: $280
B: $281
C. $246
D: $314*

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The company takes out contracts to sell gold at $315. The profit on the futures position
on November 1 is $315 - $281 = $34. The price received in the market on November 1 is
$280 + $34 = $314.

18. The futures prices of consumption commodities

A: Do not have a lower limit*

B: Do not have an upper limit
C. Have both upper and lower limits
D: Are determined by short selling

Consumption commodities cannot be sold to exploit arbitrage opportunities, or short

sold, like investment commodities. By definition, they are held for their qualities as
consumption assets. Therefore, if the futures price is below the theoretical price, there is
no arbitrage mechanism available involving shorting the asset and buying futures
(thereby driving the futures price up to its theoretical level). On the other hand, there is
nothing stopping someone from buying a consumption asset and storing it to exploit
overpricing in the futures market - hence consumption assets still have upper bounds like
investment assets.

19. The current price of gold is $400 per ounce. Storage costs are $10 per quarter payable
at the end of each quarter. Interest rates are 10% p.a. (with continuous compounding) for
all maturities. Calculate the futures price of gold for delivery in six months (rounded to
the nearest cent).

A: $442.27
B: $451.34
C: $440.76*
D: None of the above

Storage costs work in the opposite way to dividends. They increase the cost of carry and
therefore are added to the spot price

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F0 = (S0 - I)erT (dividends) becomes F0 = (S0 + U)erT where U =
the storage costs.
U = 10e-0.10*3/12 + 10e-0.10*6/12
U = 19.26539337
F0 = (419.26539337)e0.10*0.5
F0 = $440.76
20. For commodities, which are consumption rather than investment assets, in the
absence of storage costs, the theoretically correct forward price

A: Is equal to S0erT
B: Can be greater than S0erT
C: Can be greater than or equal to S0erT
D: Can be less than or equal to S0erT *

A formulaic expression of the reasoning behind question 18.

FORMULAS

R mn
Terminal value of an investment = A(1+ m)
(r −r )T
F =S e f
0 0
F0 = (S0 - I)erT

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  R 
Rc = m ln 1 + m 
 m 
 R /m 
Rm = me c −1
 
(r–q )T
F0 = S0 e

R2T2 − R1T1
Rf =
T2 − T1
N* = Beta (P/A)

-rT
f = (F0 – K)e

σS
h=ρ
σF