Test Bank for Financial Institutions and Markets, 11th Edition: Rose

Test Bank for Financial Institutions and Markets, 11th

Edition: Rose

To download the complete and accurate content document, go to:

https://testbankbell.com/download/test-bank-for-financial-institutions-and-markets-11t
h-edition-rose/

Visit TestBankBell.com to get complete for all chapters

Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

Chapter 9
Interest Rate Forecasting and Hedging:
Swaps, Financial Futures, and Options

True / False Questions

1. Interest rates tend to rise during a period of economic expansion.

TRUE

Difficulty: Medium

2. Long-term security prices tend to be more volatile than the prices of short-term securities.
TRUE

Difficulty: Easy

3. Short-term interest rates tend to be more volatile than long-term interest rates.
TRUE

Difficulty: Medium

4. Long-term securities as a rule carry more principal risk than short-term securities.
TRUE

Difficulty: Medium

5. Long-term securities carry greater income risk to the investor than short-term securities.
FALSE

Difficulty: Medium

9-1
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

6. Long-term interest rates typically rise in the late spring through mid-summer (June or July)
and fall during the winter months.
TRUE

Difficulty: Medium

7. While modest, seasonal patterns in interest rates tend to be stable over time.
FALSE

Difficulty: Medium

8. If projected money-supply growth is less than projected GNP growth interest rates are
likely to fall, other factors held constant.
FALSE

Difficulty: Hard

9. According to the Fisher effect, if the rate of expected inflation decreases, the real rate must
fall and the nominal rate also declines.
FALSE

Difficulty: Easy

10. Accurate prediction of interest rates would lead to substantial gains to the predictor.
TRUE

Difficulty: Medium

9-2
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

11. According to the expectations hypothesis, an upward-sloping yield curve implies that
investors in the financial markets expect interest rates to rise above their current levels in the
future.
TRUE

Difficulty: Easy

12. Consensus forecasts rely upon the simultaneous use of several different forecasting
methods.
TRUE

Difficulty: Easy

13. The result of an interest-rate swap is usually a lower interest rate for both swap partners
and a better balance between cash inflows and outflows for both parties to the swap.
TRUE

Difficulty: Medium

14. The notional amount of a swap never changes hands.

TRUE

Difficulty: Medium

15. Interest rate swaps represent iron clad agreements between two borrowers, so there is
never any real risk related to the performance of your partner.
FALSE

Difficulty: Easy

16. In general, the idea of an interest rate swap is to allow investors with differing credit
worthiness and funding needs to exploit their particular comparative advantage in borrowing.
TRUE

Difficulty: Medium

9-3
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

17. Airbag swaps often induce both rate ceilings and floors, protecting the participants against
losses from rising market interest rates
TRUE

Difficulty: Medium

18. A call option grants the buyer the right to purchase a specific number of securities on or
before an expiration date at a specified price.
TRUE

Difficulty: Easy

19. Swaps are used to reduce default risk.

FALSE

Difficulty: Easy

20. A swap eliminates all interest-rate risk.

FALSE

Difficulty: Medium

21. All swaps experience a change in notional principal from the first day the swap is in
force.
FALSE

Difficulty: Medium

22. The process of economic expansion and contraction is called the Wall Street Effect.
FALSE

Difficulty: Easy

9-4
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

23. The concept of futures trading is a relatively new idea.

FALSE

Difficulty: Medium

24. Futures trading is designed to protect an investor against price fluctuations.

TRUE

Difficulty: Easy

25. The advantage of hedging is that it significantly reduces risk.

FALSE

Difficulty: Easy

26. Trading in financial futures by financial institutions (such as commercial banks) is

relatively free of restrictions.
FALSE

Difficulty: Medium

27. There is a relatively stable relationship between spot and futures prices.
TRUE

Difficulty: Medium

28. Hedging can potentially reduce risk, according to the textbook.

TRUE

Difficulty: Medium

9-5
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

29. An option contract gives the buyer the right to sell a commodity or security at a set price
on or before expiration of the contract.
TRUE

Difficulty: Medium

30. Most terms of trade for futures contracts are completely controlled by the various
exchanges.
TRUE

Difficulty: Easy

31. One of the major options involving money market instruments is the Eurodollar deposit
futures option.
TRUE

Difficulty: Easy

32. The Eurodollar futures option contract is unusual because settlement is in Eurodollar
deposits.
FALSE

Difficulty: Medium

33. The Treasury bond futures option contract is traded in units of $100,000.
TRUE

Difficulty: Easy

34. In order to hedge against rising interest rates a bank would buy a call option on Eurodollar
futures.
FALSE

Difficulty: Hard

9-6
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

35. Most American style options are held to expiration.

FALSE

Difficulty: Easy

36. The purpose of a short hedge is to guarantee a desired yield in case interest rates decline
before securities are actually purchased in the cash market.
FALSE

Difficulty: Hard

37. Cross-hedging is characterized by using different types of securities in the spot and futures
markets.
TRUE

Difficulty: Easy

38. Savings and loan associations use futures to hedge the market value of their mortgage-
related securities.
TRUE

Difficulty: Medium

39. One disadvantage of the financial futures market is that it may prohibit financial
institutions from extending increased amounts of credit.
FALSE

Difficulty: Medium

40. The futures and options markets tend to promote greater efficiency in the use of scarce
financial resources.
TRUE

Difficulty: Easy

9-7
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

41. A perfect hedge is rare.

TRUE

Difficulty: Medium

42. Hedging may be compared to insurance in that it helps to protect against certain kinds of
risk exposure.
TRUE

Difficulty: Easy

43. Trading in Treasury note futures began at the Chicago Board of Trade in 1967.
FALSE

Difficulty: Medium

44. One-year T-bill futures contracts carry denominations of $250,000.

TRUE

Difficulty: Easy

45. Most options on financial instruments are traded on the New York Futures Exchange.
FALSE

Difficulty: Easy

46. Selling futures contracts can help protect a firm against an expected decline in commodity
prices.
TRUE

Difficulty: Medium

9-8
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

47. Financial futures and options contracts are less beneficial to investors heavily leveraged
with debt because their net earnings are particularly sensitive to changes in interest rates.
FALSE

Difficulty: Medium

48. Some financial analysts feel that futures and options markets, rather than helping reduce
risk and promoting the more efficient use of scarce resources, may in fact be aimed at wealthy
investors, giving them a speculative outlet for their funds and, thus, the futures and options
markets really increase risk.
TRUE

Difficulty: Medium

49. Commercial bank participation in the futures markets has been limited. One reason for
this is the accounting procedures used to recognize gains and losses from futures trading.
These accounting procedures tend to show volatile fluctuations in income for those banks
active in the futures markets.
TRUE

Difficulty: Medium

50. Hedging may be compared to insurance in that it actually reduces risk.

FALSE

Difficulty: Easy

51. Trading in the financial futures market allows an investor to sell futures contracts on
selected securities to protect against the risk of a decline in the yield of the investment.
FALSE

Difficulty: Hard

9-9
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

52. Cross hedging rests on the assumption that the prices of most financial instruments tend to
move in the same direction by roughly the same proportion.
TRUE

Difficulty: Medium

53. The spread between the cash or spot price of a commodity or security and its futures price
is known as basis.
TRUE

Difficulty: Easy

54. The risk of futures trading is the risk of changes in the basis.
TRUE

Difficulty: Medium

55. According to your text, futures trading "works" because basis risk is less than price risk on
a commodity or security.
TRUE

Difficulty: Medium

56. The notion of convergence states that the difference between spot and future prices will
approach zero as the length of time between the current and the time in which the option will
be traded approaches infinity.
FALSE

Difficulty: Easy

57. Financial futures provide the trader with a near perfect insulation to market risk.
FALSE

Difficulty: Medium

9-10
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

58. The writer of a put option benefits if the market value of the futures contract or security
stays below the option's strike price.
FALSE

Difficulty: Hard

59. For the purchaser of a put option, the option will normally be exercised for profit if the
difference between the strike price and the value of the underlying futures contract or security
exceeds the sum of the option premium, taxes and transactions costs.
TRUE

Difficulty: Hard

60. For the purchaser of a call option the option will normally be exercised for profit if the
market price of the underlying futures contract or security climbs above the sum of the strike
price, option premium, taxes and transactions costs.
TRUE

Difficulty: Hard

61. The volatility ratio is a measure of basis risk associated with a futures contract.
TRUE

Difficulty: Medium

62. The principle of convergence suggests that option prices tend to approach the value of the
underlying futures contract as the expiration date of the options approaches.
FALSE

Difficulty: Easy

63. Stock index futures contracts are settled by the transfer of ownership of a diversified
basket of stocks.
FALSE

Difficulty: Easy

9-11
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

64. Arbitrageurs hope to profit from price differences in markets around the world.
TRUE

Difficulty: Medium

65. When an investor goes "long" in the futures market, he or she expects to profit from a
decline in interest rates.
TRUE

Difficulty: Medium

66. All futures contracts trade in the same quantities and have the same delivery dates.
FALSE

Difficulty: Easy

67. In the international money market interest-rate risk associated with large commercial
loans can be dealt with using the one-month LIBOR futures contract, according to the
textbook.
TRUE

Difficulty: Medium

68. Jefferson County Alabama experienced fiscal troubles due to the amount of bad swaps
they engaged in.
TRUE

Difficulty: Easy

9-12
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

69. Normally arbitrage trading based upon price difference between two different securities
markets is highly risky due to the simultaneous holding of both long and short positions.
FALSE

Difficulty: Medium

70. The Federal funds futures contract traded on the Chicago Board of Trade's exchange
covers 90 days.
FALSE

Difficulty: Medium

71. Most financial futures trading centers on U.S.T-bill contracts.

TRUE

Difficulty: Medium

72. When interest rates rise, asset prices normally fall and this is particularly true of fixed
income securities.
TRUE

Difficulty: Medium

73. Interest rates are notoriously difficult to predict, however they do tend to follow the
business cycle.
TRUE

Difficulty: Medium

74. Implied market forecasts are predictions that are based on the interest rate expectations of
the market.
TRUE

Difficulty: Medium

9-13
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

76. Research has increasingly pointed towards time patterns in market interest rates that come
close to a random walk, that is, it can be predicted on a consistent basis.
FALSE

Difficulty: Medium

77. Derivatives have recently come under greater scrutiny due to their possible role in the
great credit crisis of 2007-2009.
TRUE

Difficulty: Medium

78. Investors interested in hedging may buy a futures contract in order to lock in a price on a
specific asset at a future date.
TRUE

Difficulty: Medium

79. Hedging in the futures market reduces the overall risk in the market.
FALSE

Difficulty: Hard

80. A key feature of the futures market that allows the hedging process to transfer risk
effectively is the fact that prices in the spot market are generally correlated with prices in the
futures market.
TRUE

Difficulty: Hard

9-14
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

81. Hedging essentially involves adopting equal and opposite positions in the spot and futures
markets for the same assets.
TRUE

Difficulty: Medium

Multiple Choice Questions

82. According to the textbook the investor who chooses long-term securities over comparable
quality short-term securities encounters:
A. Greater income risk
B. Greater principal risk
C. More stable market prices
D. More volatile interest rates
E. None of the above

Difficulty: Medium

83. According to your text, during a period of economic expansion:

A. Debt security prices typically rise
B. Interest rates tend to fall
C. Long-term interest rates increase faster than short-term interest rates
D. Interest rates typically rise
E. None of the above

Difficulty: Medium

84. The measure of the nation's money supply that includes only currency and coin held by
the public plus transaction (payments) accounts is known as:
A. M1
B. M2
C. M3
D. Debt
E. None of the above

Difficulty: Easy

9-15
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

85. According to the liquidity effect an increase in money supply growth relative to money
demand in the short run leads to:
A. Higher interest rates
B. Lower interest rates
C. Higher inflation
D. Lower inflation
E. None of the above

Difficulty: Medium

86. If the economy is experiencing an economic boom, interest rates will likely:
A. Rise
B. Fall
C. Remain stable unless inflation (the Fisher effect) intervenes
D. Remain unchanged unless the business cycle turns downward with slower GNP growth
E. None of the above

Difficulty: Hard

87. Futures contracts on 90-day U.S. Treasury bills for delivery in 3 months carried a yield
today of 10.25 percent while futures contracts on comparable T-bills for delivery in 6 months
carried a yield of 10.625 percent. Today's yields on 90-day bills for immediate (cash) delivery
are 10.12 percent. The implied market forecast is that interest rates will:
A. Rise between today and 6 months from today
B. Fall for the next 3 months, but rise thereafter
C. Rise over the next 6 months
D. Fall over the next 6 months
E. None of the above

Difficulty: Hard

9-16
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

88. A swap can be effectively hedged against interest-rate risk by:

A. Selling out to another party
B. Entering into another swap agreement that is the mirror image of the first swap
C. Setting interest-sensitive assets equal to interest-sensitive liabilities
D. Setting asset duration equal to liability duration
E. None of the above

Difficulty: Hard

89. Short-term interest rates tend to be ____ sensitive to business cycle changes than are long-
term interest rates.
A. More
B. Less
C. Equally
D. More sensitive in a boom and less sensitive in a recession
E. More sensitive in a recession and less sensitive in a boom

Difficulty: Medium

90. A interest rate swap contract whose notional principal can vary due to changes in market
interest rates is known as a(n):
A. Variable principal swap
B. Variable rate swap
C. Index amortizing rate swap
D. Fluctuating notional swap
E. None of the above

Difficulty: Easy

9-17
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

91. A swap counterparty that pays out a fixed rate and collects a floating rate is said to be in a
_ position.
A. Hedged
B. Short
C. Straddled
D. Long
E. None of the above

Difficulty: Medium

92. Financial institutions in swap transactions are frequently in a hedged position, meaning
that the financial institution both pays and receives both floating and fixed interest rates. Can
a financial institution make any money in this position?
A. No, the hedging matches cash inflows and outflows
B. Yes, because most financial institutions buy Libor deposits at a cheaper, wholesale rate
C. No, the financial institution just hedges to protect against loss
D. Yes, the financial institution can charge arrangement fees and can "skim," or pay less to
one counterparty than it collects from the other
E. None of the above

Difficulty: Hard

93. In the financial futures markets, the length of contracts normally ranges from three months
to:
A. 6 months
B. 1 year
C. 18 months
D. 2 years
E. None of the above

Difficulty: Medium

9-18
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

94. The basis for a futures contract is the:

A. Spread between cash and futures market price
B. Contract denomination currently traded
C. Price of contract agreed upon between buyer and seller
D. Lowest price set the day the contract was traded
E. None of the above

Difficulty: Easy

95. Futures contracts on T-bills have maturities of:

A. 30 - 90 days
B. 90 days - one year
C. 60 - 90 days
D. 1 - 2 years
E. None of the above

Difficulty: Medium

96. The denomination for 90-day T-bill contracts is:

A. $250,000
B. $500,000
C. $750,000
D. $1 million
E. None of the above

Difficulty: Easy

97. The principal active traders in financial futures and options in the U.S. are:
A. Individual traders and managed futures funds
B. Commercial banks and savings and loans
C. Managed futures funds and mortgage banks
D. None of the above

Difficulty: Medium

9-19
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

98. One of the most active markets for forward delivery of an asset to be found anywhere in
the world is the futures market for:
A. U.S. Treasury bonds and notes
B. U.S. Treasury bills
C. GNMA mortgage-backed certificates
D. Commercial paper
E. Bank CDs

Difficulty: Medium

99. A contract which gives the buyer the right to buy a security at a set price on or before the
contract's expiration date is called:
A. A put option
B. A futures contract
C. A short hedge
D. A call option
E. None of the above

Difficulty: Easy

100. The most popular exchange-traded option on a capital market instrument is:
A. Treasury bill futures
B. Stock indexes
C. Eurodollar futures
D. Treasury note futures
E. Treasury bond futures

Difficulty: Medium

101. In order to buy an option, one must pay the writer a:

A. Strike price
B. Market price
C. Margin
D. Premium
E. Basis

Difficulty: Easy

9-20
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

102. The mark-to-market daily feature of financial futures requires:

A. Prices of the option to be set daily by the trading house
B. A daily renegotiation of contract terms by the participants based on the current market
conditions
C. A daily royalty paid by the contract participants to the trading house
D. The posting of daily market updates for the benefit of the contract participants
E. Any gains or losses posted on futures contracts to be credited or debited to the contract
participant’s accounts at the close of each day

Difficulty: Medium

103. Which of the following is true regarding U.S. Treasury bonds traded in the futures
market?
A. Contracts for future delivery can be written on bonds with 90 day or 1-year maturities
B. Are standard, readily marketable instruments with interest rates higher than on U.S.
Treasury securities traded in the cash market
C. Futures trading in bonds is extremely light compared with other securities
D. They offer the investor an opportunity to hedge against changing rates on commodity loans
E. Maturities must be at least 15 years or cannot be called for 15 to 20 years

Difficulty: Medium

104. The development of financial futures markets for securities was prompted by:
A. Large gains being realized in commodity futures
B. Financial regulatory authorities
C. Volatile interest rates
D. GNMA mortgage-backed securities
E. None of the above

Difficulty: Medium

9-21
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

105. Which of the following instruments is not generally traded in the financial futures
market?
A. U.S. T-bills
B. Treasury bonds and notes
C. Eurodollar deposits
D. Common stock indices
E. All of the above are generally traded

Difficulty: Medium

106. Which of the following statements is true?

A. A long hedge involves the purchase of futures contracts before the investor must buy the
actual securities
B. The purpose of a long hedge is to guarantee a desired yield
C. The immediate sale of financial futures contracts is characteristic of a short hedge
D. A combined transaction between the spot and futures markets using different types of
securities in each is a cross hedge
E. All of the above

Difficulty: Hard

107. A thrift with a large fixed-rate mortgage portfolio wants to protect itself against an
increase in interest rates. It should:
A. Buy Treasury bond futures contracts
B. Sell Treasury bond futures contracts
C. Buy Treasury bill futures contracts
D. Sell Treasury bill futures contracts
E. Buy stock index futures contracts

Difficulty: Medium

9-22
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

108. An insurance company expects to receive a large payment in three months. When the
payment is received, it will be invested in short-term securities. It can hedge against a change
in interest rates if it:
A. Buys Treasury bond futures contracts
B. Sells Treasury bond futures contracts
C. Buys Treasury bill futures contracts
D. Sells Treasury bill futures contracts
E. Buys stock index futures contracts

Difficulty: Medium

109. The buyer of a put option on Treasury bonds:

A. Is hedging against a decline in the price of Treasury bonds
B. Can lose the entire amount of the contract if rates move adversely
C. Has an unlimited time in which to exercise the options
D. Determines the strike price if the option is traded on the exchange
E. Will profit if interest rates fall

Difficulty: Medium

110. One of the instruments listed below is not currently traded on a futures and options
exchange. This instrument is:
A. Municipal bonds
B. Eurodollar time deposits
C. Swiss francs
D. Banker's acceptances
E. U.S. Treasury notes

Difficulty: Hard

111. As the delivery date specified in the futures contract draws nearer:
A. The gap between the futures and spot prices for the same asset narrows
B. The basis between the futures and spot prices for the same asset narrows
C. The spot and forward price becomes equal at the specified contract date
D. All of the above
E. None of the above

Difficulty: Medium

9-23
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

112. When interest rates rise:

A. Asset prices normally fall
B. Fixed income securities normally fall
C. Asset prices normally increase
D. A and B above
E. None of the above

Difficulty: Hard

113. Research has increasingly pointed towards time patterns in market rates that come close
to a(n):
A. Efficient market
B. Random walk
C. Strong form of efficient market
D. All of the above
E. None of the above

Difficulty: Medium

114. The principal measure of risk in financial futures is the:

A. Basin
B. Mark-to-market
C. Basis
D. Put-call parity
E. None of the above

Difficulty: Medium

115. Hedging in the futures market:

A. Reduces the overall risk in the market
B. Does not affect the risk in the market
C. Does not reduce the risk in the market
D. B and C above
E. None of the above

Difficulty: Hard

9-24
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

116. A low-cost method of transferring the risk of unanticipated changes in asset prices or
interest rates from one investor or institution to another is called:
A. Convergence
B. Hedging
C. Investing
D. Securitization
E. None of the above

Difficulty: Hard

117. A key feature of the futures market that allows the hedging process to transfer risk
effectively is the fact that:
A. Prices in the spot market are not generally correlated with prices in the futures market
B. Prices in the spot market are generally correlated with prices in the futures market
C. Price standardization
D. Asset standardization
E. None of the above

Difficulty: Medium

118. Hedging essentially involves adopting equal:

A. Positions in the spot and futures markets for the same assets
B. Shares of stock in the same firm
C. But opposite positions in the spot and futures markets for the same assets
D. All of the above
E. None of the above

Difficulty: Medium

119. As the delivery date specified in the futures contract draws nearer, the gap or basis
between the futures and spot prices for the same asset narrows and is termed:
A. Zeroing out
B. Approaching zero
C. Convergence
D. Divergence
E. None of the above

Difficulty: Medium

9-25
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

120. The futures markets work to offset risk, because the risk of change in basis is generally:
A. Easy to predict due to asset price changes being easy to predict
B. Well-known
C. Less than the risk of changes in the price or yield of an asset
D. A and B above
E. None of the above

Difficulty: Medium

121. Exchange traded put and call options have grown rapidly in recent years and are focused
on instruments such as:
A. 30-day federal funds futures
B. Your dollar and euro deposit futures
C. U.S. treasury bills and notes and bonds futures
D. All of the above
E. None of the above

Difficulty: Medium

122. More recently, options have been offered on:

A. ETFs
B. LEAPs
C. FLEX
D. All of the above
E. None of the above

Difficulty: Medium

9-26
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

Matching Questions

123. Choose the definition or descriptive phrase on the right that best describes the term on
the left.

1. Terms Definitions or Descriptive Phrases 1

2. Fisher Effect Period during which interest rates normally decline. 16
3. Liquidity
Effect Period over which interest rates normally rise. 14
4. Notional
Amount The likelihood or probability of greater capital loss. 6
5. Expectations The likelihood or probability that the investor's rate of
Effect return will not be stable. 13
Increased growth in the nation's money supply reduces
6. Principal Risk interest rates in the short-run. 3
7. Financial Actual money growth exceeding expected money
Futures growth causes interest rates to rise. 5
An increase in total spending in the economy increases
8. Interest-Rate the public's demand for money and, with money supply
swaps unchanged, leads to higher interest rates. 19
The nominal interest rate of a loan must equal the
9. Forward lender's expected real rate of return plus the expected
Calendar inflation rate. 2
10. Unmatched
swaps A listing of planned security offerings. 9
11. Yield Curve Provides investors with an implied market forecast. 11
Contracts calling for a designated amount of securities
12. Swap brokers to be delivered days, weeks or months from today. 7
Use of several different rate prediction methods
13. Income Risk simultaneously. 15
14. Economic The buyer receives the right, but not the obligation, to
Expansion sell and deliver securities or futures contracts. 20
The buyer receives the right, but not the obligation, to
15. Consensus purchase securities or futures contracts at an agreed upon
Forecast price. 18
Two contracting parties agree to pay all or a portion of
16. Recession each other's borrowing costs. 8
Dollar amount that never changes hands between two
17. IAR swap parties to a contract. 4
18. Call Option Financial firms that bring two parties together. 12
19. Income Effect A swap agreement with only one signed party. 10
A contract between two parties to exchange interest
payments in which the value of the notional principal in the
20. Put Option swap changes with short-term interest rates. 17

9-27
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

Difficulty: Medium

124. Choose the definition or descriptive phrase on the right that best describes the term on
the left.

1. Hedging Definitions or Descriptive Phrases 16

Contract calling for future delivery of a specific
2. Put Options security at a set time and price. 9
The act of buying or selling a commodity or claim
3. Long Hedge to protect against the risk of future price fluctuations. 1
4. Eurodollar Deposit
Futures Option Contracts away all risk of asset price fluctuations. 13
5. Cross Hedge Also known as the spot market. 7
6. Treasury Note
Futures Another term for futures market. 11
7. Cash Market First site of financial futures trading in the U.S. 10
Contract for securities with maturities of at least
8. Short Hedge 15 years. 12
Contract for securities with 4- to 6-year maturities
9. Financial Futures with an 8-percent base coupon rate. 6
10. Chicago Board of
Trade Contract on 90-day and 1-year maturity securities. 14
Gives the buyer the right to sell the security at a set
11. Forward Market price. 2
The price at which the underlying futures contract
or securities may be bought or sold if an option is
12. Treasury Bond exercised. 15
13. Perfect Hedge Settled in cash. 4
The purchase of futures contracts today in
14. Treasury Bill anticipation of a purchase of actual securities at a later
Futures date in order to lock in a desired yield. 3
Immediate sales of futures contracts until actual
securities must be sold later in the cash market to
15. Strike Price protect against declining security prices. 8
A combined transaction between spot futures
markets using different types of securities in each
16. Terms market. 5
As the delivery date specified in the futures
contract draws nearer, the basis between the futures in
17. Convergence the spot prices for the same asset narrows. 17

Difficulty: Medium

9-28
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

Short Answer Questions

125. Describe the relationship between changes in economic activity and market interest rates.
Why is it that interest rates usually rise during periods of economic expansion and fall when
the economy is headed down into a recession?
ANS: Interest rates tend to rise and fall with the level of economic activity. Economic
expansions (booms) generally lead to increases in both short-term and the long-term interest
rates, while recessions generally result in a decline in all rates, sooner or later. This pattern
apparently reflects shifting demands for credit as credit demands fall relative to the supply of
loanable funds in periods of recession and increase relative to loanable-funds supply in
periods of expansion.

Difficulty: Medium

126. Long-term and short-term interest rates behave somewhat differently over the course of a
business cycle of expansion and contraction. Please describe the differences in behavior
between short and long-term interest rates that are typically observed.
ANS: Both long-term and short-term interest rates tend to rise and fall together, though lags
are often observed with short-term rate changes often preceding long-term rate changes. Over
the course of the business cycle short-term rates tend to rise faster than long-term rates in a
period of expansion and decline faster than long-term rates in a recession. The result is
marked changes in the shape of the yield curve with each cyclical phase. These changes
probably reflect the influence of public expectations and the fact that long-term rates can be
expressed as geometric averages of short-term interest rates. Also longer-term securities have
more cash flow terms to be affected by changing interest rates than do short-term securities.

Difficulty: Medium

9-29
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

127. Which rises or falls at a faster-rate – long-term interest rates or short-term interest rates?
Can you explain why?
ANS: Over the course of the business cycle short-term rates tend to rise faster than long-term
rates in a period of expansion and decline faster than long-term rates in a recession. The result
is marked changes in the shape of the yield curve with each cyclical phase. These changes
probably reflect the influence of public expectations and the fact that long-term rates can be
expressed as geometric averages of short-term interest rates. Also longer-term securities have
more cash flow terms to be affected by changing interest rates than do short-term securities.

Difficulty: Medium

128. Are market interest rates subject to seasonal movements? When do short-term interest
rates tend to rise due to seasonal pressures? What about long-term interest rates?
ANS: Just as interest rates change with cycles in business activity, there is evidence that
interest rates also display seasonality, tending to be higher at some times of the year than at
others. Short-term rates tend to be pushed somewhat higher through summer and fall due to
rising seasonal demand for short-term funds, especially as businesses stock their shelves with
inventory for the Fall season. From January through May, on the other hand, slackening
demand for short-term credit encourages short-term interest rates to fall, other factors held
equal. Long-term interest-rates tend to experience upward pressure in the late spring through
midsummer (June or July), related to heavy construction activity during this time of the year
and often approach seasonal lows during the winter months.

Difficulty: Medium

129. What leading financial institution can offset or dampen seasonal interest-rate changes?
ANS: The seasonal patterns are easily overridden by other factors, such as changes in the
economy or in government policy. For example, central banks like the Federal Reserve
System frequently use their monetary policy tools to counteract seasonal changes in the
supply and demand for loanable funds.

Difficulty: Easy

9-30
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

130. For what reasons are interest rates so difficult to forecast accurately?
ANS: Interest rates are influenced by the borrowing and lending decisions of thousands of
individuals and institutions. No forecasting model is complex enough to reflect the
complexity of such decisions working their way through the financial system.

Difficulty: Easy

131. Suppose you could forecast interest rates correctly on a consistent basis. What
advantages would this give to you?
ANS: Of course, being able to forecast where interest rates are going would be a distinct
advantage to both borrowers and lenders of funds. Borrowers could choose to borrow when
the "price" of credit was lowest, while lenders could more fully take advantage of high-rate
periods.

Difficulty: Easy

132. Regarding a call option and a put option, explain each option’s purpose and describe
what the option writer is obligated to do for each.
ANS: A call option grants the option holder the right to call in an order for the asset at the
determined strike price on or before the expiration of the option. In this case, the option writer
is obligated to sell the assets to the option holder at the strike price if the option holder
chooses to exercise his option.
A put option grants the option holder the right to put their holdings of assets for sale at the
determined strike price on or before the expiration of the option. In this case, the option writer
is obligated to purchase the assets from the option holder for the strike price if the option
older chooses to exercise his option.

Difficulty: Medium

133. What variables are used most frequently in econometric models to predict changes in
interest rates?
ANS: Interest rates in econometric models are typically linked to variables like current and
lagged values of money, income or total spending and past rates of inflation. The larger
models simultaneously measure changes in total spending on goods and services, business
investment, inflation, employment and a broad spectrum of interest rates.

Difficulty: Medium

9-31
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

134. How can public opinion affect interest rates? Why might public opinion be important in
interest-rate forecasting?
ANS: In the expectations hypothesis, the slope of the yield curve itself implies a forecast of
interest rate changes expected by the public. Public opinions about the future can play an
important role in influencing the interest rate, since if a large number of people believe that
the nominal interest rate is moving up (due to the pressure of inflation), their collective
behavior may indeed increase pressure to boost up the interest rate.

Difficulty: Medium

135. How can the marketplace's expectations be used as a guide to anticipate future changes
in interest rates? What are the pitfalls in using such an expectations approach as a forecasting
tool?
ANS: The financial markets reveal the public's expectations at any given moment regarding
the future course of interest rates. These expectations are reflected most directly in the shape
of the yield curve and in the prices and yields on securities traded for future delivery in the
financial futures market. Upward-sloping yield curves generally point to an expectation of
rising interest rates, for example, while declining yields on securities whose futures contracts
are being priced today suggest lower interest rates between now and when those futures
contracts mature. The biggest problem with such implied market forecasts is that current
expectations about the future may turn out to be incorrect. Moreover, expectations often
change rapidly, sometimes in a matter of minutes or hours, as new information reaches the
markets.

Difficulty: Medium

136. What is interest-rate hedging? What is its goal?

ANS: Interest-rate hedging refers to the act of coordinating the buying and selling of a
commodity or financial claim to protect against the risk of interest rate fluctuations. Interest-
rate hedging tends to lower interest rate risk, by transferring the risk of unanticipated interest
rate changes to another investor or institution. However, it also tends to reduce the profit
potential that could result from future interest rate changes.

Difficulty: Medium

9-32
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

137. What are interest-rate swaps? Why were these instruments developed?
ANS: In an interest rate swap, two participating business firms independently borrow money
and then exchange interest payments with each other for a stipulated period of time. In effect,
each company helps to pay off a portion of the interest cost owed by the other firm. The result
is usually lower interest expense for both firms and a better balance between cash inflows and
outflows for both firms. Swaps give a company a powerful tool in managing its liabilities,
helping to offset any maturity mismatches that may exist between its assets and liabilities.

Difficulty: Medium

138. What risks are associated with swap contracts? Can any of these risks be reduced?
ANS: Swaps are not without risk. Either party to the agreement may go bankrupt or even steal
the funds owed to its counterparty, leaving its partner exposed to interest rate risk. Swaps help
to cover interest rate risk, but do not necessarily reduce credit (default) risk. A few swaps call
for one or both parties to post collateral, but this is usually not done. Unfortunately, without
collateral requirements, it is easy for a swap partner to overdo the use of swaps and get itself
into trouble. Moreover, swaps are subject to interest rate risk due to the fact that shifts in
market interest rates can alter the value of existing swaps agreements and, therefore, affect a
swap's replacement cost. A swap can be hedged against interest rate risk by entering into
another swap agreement that is the mirror image of the first (a matched pair). Some
companies use swaps futures contracts or other hedging tools to counter interest rate risk from
their swaps rather than proliferating still more swaps.

Difficulty: Medium

139. When is a partner to a swap in a long position? A short position? To what kinds of risk is
each exposed to?
ANS: A long position means the swap partner is paying a fixed rate and receiving a floating
rate. A swap partner in a long position that borrows at a floating interest rate loses the chance
to save on interest expenses should interest rates fall. A swap partner in a short position does
the exact opposite, paying a variable interest rate to its partner and receiving a fixed interest
rate in return. A swap partner in a short position that borrows at a fixed long-term rate risks
higher interest expenses when interest rates rise. In the hedged position, the financial
institution both pays and receives both floating and fixed interest rates.

Difficulty: Medium

9-33
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

140. How do the spot (cash) markets differ from futures (forward) markets?
ANS: Spot market prices are the actual prices available at the time of sale. Futures prices
represent an estimate of what the spot market price will be on the contract's delivery date.

Difficulty: Medium

141. What is basis? Explain how the basis for a futures contract relates to trading risk.
ANS: Basis refers to the spread between the cash-market price and futures-market price for
the same commodity or security at the same point in time. Basis risk is the principal type of
risk encountered by futures traders. Hedging through futures converts price or interest rate
risk into basis risk. Futures trading helps the investor hedge against price and interest-rate
changes because basis risk is usually less than price risk.

Difficulty: Medium

142. Which type of hedge named above works best in an environment of rising interest rates?
Of falling interest rates? Can you illustrate this using a payoff diagram?
ANS: The purpose of the long hedge is to guarantee (lock in) a desired yield in case interest
rates decline (i.e. asset prices increase) before assets are actually purchased in the cash
market. On the other hand, short hedges are especially useful to investors who may hold a
large portfolio of assets they plan to sell in the future, but in the meantime, want to be
protected against the risk of declining prices (i.e. rising interest rates).

Difficulty: Medium

9-34
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

143. What type of option contract is appropriate in an environment of rising interest rates?
Falling interest rates? Please illustrate this using payoff diagrams.
ANS: Call options can be used to protect the buyer against falling interest rates or rising
prices in securities that will be purchased in the future. Puts can be used to protect the buyer
against rising interest rates or falling prices and their negative effects on borrowing costs and
asset values.

Difficulty: Medium

9-35
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

144. What risks and costs are inherent in financial futures and options trading?
ANS: The principal risk in futures and options trading is basis risk -- that is, differing price
movements between futures and cash markets. It is rare that these will be exactly the same.
Moreover, costs include brokerage commissions and margin calls. The social benefits of some
futures and options trading are limited to the extent transactions costs are significant and
speculation is encouraged.

Difficulty: Medium

9-36
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

145. In an interest-rate swap transaction, a large corporation can borrow in the bond market at
a current fixed rate of 9 percent and can also obtain a floating-rate loan in the short-term
market at the prime bank rate. However, this firm wishes to borrow short-term because it has
a large block of assets that roll over into cash each month. The other party to the swap is a
company with a lower credit rating that can borrow in the bond market at an interest rate of
11.5 percent and in the short-term market at prime plus 1.50 percent. This lower-rated
company has long-term predictable cash inflows, however. The higher-credit-rated company
wishes to pay for its part in the swap an interest rate of prime less 50 basis points. The lower-
rated company is willing to pay the underwriting cost associated with the higher-rated
company's security issue, which is estimated to be 25 basis points. The swap transaction is
valued at $100 million. What kind of interest rate swap can be arranged here? Which
company will borrow short term and which long term? If the prime bank rate is currently 10
percent, who will pay what interest cost to whom? Explain what the benefit is to each party in
this swap.
ANS: The swap between these two parties will look like this:
▪ High-rated borrower borrows long-term at 9 percent.
▪ Low-rated borrower borrows short-term at prime +1.50 percent.
▪ The high-rated borrower pays prime -0.50 percent.
▪ The low-rated borrower pays 9 percent fixed +0.25 percent.

If the prime rate is 10 percent at present, the high-rated borrower legally would owe 9.50
percent (10-0.50) and the low-rated borrower would need to pay 9 percent (assuming that the
underwriting cost has been paid separately). In this instance the high-rated borrower, owing
more, would have to send the low-rated borrower a check for the 0.50 percent (9.50-9.00)
difference in loan rates.
In this particular swap, the high-rated borrower effectively "borrows" at prime – 0.5%, a
saving of 0.50% over what it would have to pay for an equivalent floating-rate loan in the
short-term market (i.e. prime bank rate). The low-rated borrower effectively "borrows" at a
fixed rate of 9+.25+1.5–(–.5)=11.25%, a saving of 0.50% over what it would have to pay for
an equivalent loan in the bond market (i.e. 11.5% +.25%, assuming that it will also incur an
underwriting cost of 0.25%).

Difficulty: Medium

9-37
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

146. What position in the swap market does each of the following parties occupy?
a. INTEX Corporation pays a fixed interest rate of 9 percent and receives a floating interest
rate equal to the 3– month Treasury bill rate. INTEX is in a long Position in the swap market.
b. Cross Timbers International, Ltd. pays out an interest rate based on the 6 – month LIBOR
rate and receives a long-term, fixed rate of 10 percent. Cross Timbers International, Ltd. is in
a short Position in the swap market.
c. Montgomery Securities pays out and also receives an interest rate based upon a flexible 12-
month LIBOR interest rate and also receives a fixed rate of 9.5 percent, while paying out a
fixed rate of 9.3 percent. Montgomery Securities occupies a hedged position in the swap
market.

Difficulty: Medium

147. An insurance company committed itself during the month of March to buying a block of
home mortgages at a fixed price from a mortgage banker in September. The mortgages have a
face value of $10 million. The insurer has recently prepared a forecast that indicates that
mortgage interest rates will rise between now and September by a full percentage point. What
kind of futures transaction would you recommend to protect the insurance company against a
sizable loss on its mortgage commitment, particularly if it has to sell the mortgages shortly
after they are taken into its portfolio. Indicate specifically what buy and sell transactions you
would undertake in the futures market. What futures contract would you most likely use?
Why? What options contract seems best and why?
ANS: Engage in a short hedge by selling 100 December Treasury bond futures contracts.
When the insurance company must actually purchase the block of mortgages, it will buy 100
similar contracts. The prices of these should move similarly to the prices of the mortgages in
this example of a cross hedge. If the insurance company decides to use options it should buy
100 December puts on Treasury bond futures. When it buys the mortgages, it could exercise
the option, take a short position in the futures market and then buy the corresponding futures
to close the position.

Difficulty: Medium

9-38
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

148. A large money center bank plans to offer money market CDs in substantial volume (at
least $100 million) in six months due to a projected upsurge in credit deals from some of its
most valued corporate customers. Unfortunately, the bank's economist has just predicted that
money market interest rates should rise over the next year (with perhaps a full 1.5 percentage
point increase within the next six months). Explain why the bank's management would be
concerned about this development. Then, suppose management expects its corporate loan
customers to resist any loan terms that would automatically result in loan rates being
immediately adjusted upward to reflect any rate increases in the money market. What futures
market transaction would you recommend? What is the best options contract alternative for
the bank?
ANS: A rise in interest rates would result in an increase in the bank's cost of funds. Engage in
a short hedge by selling 100 futures contracts involving Eurodollars. If interest rates do rise,
the bank will have to pay higher rates on its CDs, but the value of the contracts will fall,
resulting in a gain when 100 similar contracts are purchased. The best options contract would
be to buy 100 puts on Eurodollars futures. If rates do rise, the puts should be "in the money."
The bank should exercise the puts.

Difficulty: Medium

149. An investment banking firm discovers that 90 days from today, it is due to receive a cash
payment from one of its corporate clients of $972,500. The firm's portfolio manager is
instructed to plan to invest this new cash for a horizon of three months, after which it will
need to be liquidated. Interest rates are attractive today at 10 percent, but a steep decline is
forecast due to a developing recession. The portfolio manager decides to try to guarantee a 9
percent rate of return today on this planned three-month investment of cash.
a. Describe what the manager should do today in the financial futures market. Then, indicate
how he will close out the futures position eventually. The portfolio manager should buy a 90-
day Treasury bill futures contract. Thus, if interest rates do fall, the futures contract will gain
in value. When the cash becomes available, he or she should sell the same futures contract
and invest in the cash instrument.
b. What are the appropriate (buy-sell) steps for the manager if options on financial futures are
to be used? The portfolio manager should buy a call on Treasury bill futures. If the index on
Treasury bill futures rises above the strike price (i.e., interest rates fall), then he or she should
exercise the option.

Difficulty: Medium

9-39
Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

150. During the month just concluded, the prices of U.S. Treasury bonds fluctuated between a
price of $95 (based on a $100 par value) and a price of $93. Treasury bond futures over the
same period fluctuated between $92 and $88 (based on a $100 par value). How did the basis
for T-bond futures contracts change over this period? What was the volatility ratio for T-bond
futures for the month just ended? Using the volatility ratio you have just calculated and
assuming you wish to hedge for the next 30 days $25 million in Treasury bonds that you
currently hold with $100,000 denomination T-bond futures contracts maturing in 90 days,
how many T-bond futures contracts will you need to buy to fully cover the $25 million in
securities at risk?
ANS: Assuming the comparative prices quoted on U.S. Treasury bonds and bond futures
occurred at the same point in time, the basis for these bonds would have changed from $95-
$92 or $3 per $100 to $93-$88 or $5 per $100. The volatility ratio would be:
Volatility ratio = % change in cash price = 2.15% = 0.484
% change in futures price 4.35%
In order to protect $25 million in T-bonds for 30 days the following number of contracts
would be needed:
Number of futures = $25 million x 0.484 x 30 days = 40.4 contracts
Contracts needed $100,000 90 days

Difficulty: Medium

151. Please identify which term or concept presented in this chapter matches each of the
following definitions.
a. Fluctuations in economic activity. Business cycle.
b. Patterns in market interest rates during the year. Seasonality.
c. Money supply increases push interest rates downward. Money-supply liquidity effect.
d. Actual money growth versus expected money growth. Money-supply expectations effect.
e. Changes in spending and income receipts result in interest rate movements in the same
direction. Money-supply income effect.

Difficulty: Medium

9-40
Test Bank for Financial Institutions and Markets, 11th Edition: Rose

Chapter 9 - Interest Rate Forecasting and Hedging: Swaps, Financial Futures, and Options

152. Please identify which term or concept presented in this chapter matches each of the
following definitions.
a. Systems of equations designed to predict or explain interest rate movements. Econometrics
model.
b. Securities expected to be offered for sale in future periods. Financial futures contracts.
c. Market's expectation concerning future interest rate levels. Implied rate forecast.
d. U se of several different forecasting approaches. Consensus forecast.
e. Two borrowers exchange interest payments. Interest-rate swaps.

Difficulty: Medium

153. Please identify which term or concept presented in this chapter matches each of the
following definitions.
a. Using financial tools to protect against fluctuations in financial asset prices or interest rates.
Hedging.
b. The spread between the spot and forward prices of a financial asset. Basis.
c. Contracts applying to the forward sale of assets at a price set when the contract is made.
Financial forward contracts.
d. Simultaneous purchase and sale of stocks and futures contracts in order to profit from
temporary price differences. Arbitrage.
e. Purchase of futures contracts. Long hedge.

Difficulty: Medium

154. Please identify which term or concept presented in this chapter matches each of the
following definitions.
a. Sale of futures contracts. Short hedge.
b. Trading different financial assets in futures and cash (spot) markets. Cross hedge.
c. Price of acquiring financial assets listed in an option contract. Strike price.
d. Right to purchase a specified volume of assets at a specified price before expiration. Call
option.
e. Right to sell a specified volume of financial assets at a specified price before expiration.
Put option.
f. Price of an option. Option premium.

Difficulty: Medium

9-41

Visit TestBankBell.com to get complete for all chapters