Chap023

Chapter 23 - Risk Management: An Introduction to Financial Engineering

Chapter 23Risk Management: An Introduction to Financial Engineering

Multiple Choice Questions

1. Farmer Jones raises several hundred acres of corn and would suffer a significant loss should the price of corn decline at harvest time. Which one of the following would he be doing if he purchased financial securities to offset this price risk? A. abatingB. derivingC. hedgingD. forwardingE. manipulating

2. The value of a stock option is dependent upon the value of the underlying stock. Thus, a stock option is a: A. forward agreement.B. derivative security.C. mezzanine asset.D. contingent security.E. junior security.

3. Farmer Mac owns a large orange grove in Florida. The value of his business is directly related to the price of oranges. Which one of the following is a graphical representation of this price-value relationship? A. exchange lineB. net present value profileC. risk profileD. market lineE. return grid

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4. Farmer Ted planted 200 acres in wheat this year. The weather has been perfect and he expects to harvest a record crop within the next two weeks. At present, he has no storage facilities and therefore must sell his crop as soon as it is harvested. Which one of the following risks is he facing because he must sell his crop at whatever the market price is at harvest time? A. futures riskB. volatility exposureC. surplus riskD. transactions exposureE. translation exposure

5. For years, your family has operated a business that produces lawn mowers. Over the years, the industry has progressed and new mass production techniques have been developed. However, your firm cannot afford this new technology, nor can you compete against those firms that can. Thus, the family has decided to close its facility at the end of the year. Which one of the following describes the risks to which your family's firm succumbed? A. forward riskB. volatility exposureC. economic exposureD. transactions exposureE. translation risk

6. This morning a cereal maker agreed to pay a farmer $4.40 a bushel for 5,000 bushels of wheat that the farmer will ship to the factory four months from now. What is this legally binding agreement called? A. forward contractB. spot contractC. swapD. exchangeE. floating contract

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7. A graph depicting the gains and losses a seller of a forward contract would earn at various market prices is referred to as a: A. risk profile.B. payoff profile.C. risk offer line.D. scatter plot.E. risk-return graph.

8. By definition, which one of the following contracts is marked to the market on a daily basis? A. forward contractB. spot contractC. hedgeD. swapE. futures contract

9. Southern Groves raises tangerines. To hedge its risk, the firm trades in the orange futures market. This process is known as: A. secondary trading.B. open trading.C. open-hedging.D. cross-hedging.E. perfect-hedging.

10. The National Bank has an agreement with The Foreign Bank to exchange 500,000 U.S. dollars for 380,000 Euros on the first day of each of the next 3 calendar quarters. This agreement is best described as a(n): A. floating exchange.B. spot trade.C. option.D. futures contract.E. swap contract.

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11. An agreement that grants its owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time is called a(n) _____ contract. A. optionB. forwardC. futuresD. swapE. spot

12. Sue recently purchased a right to buy 100 shares of ABC stock for $27.50 a share if she so chooses at any time within the next four months. Which one of the following does Sue own? A. futures contractB. call optionC. put optionD. straddleE. strangle

13. Steve recently sold an option that requires him to purchase 100 shares of Omega stock at $40 a share should the option owner decide to exercise the option. What type of option contract did Steve sell? A. futures optionB. call optionC. put optionD. straddleE. strangle

14. Which one of the following statements is correct? A. Price levels increased more in the late 1800's than they did in the late 1900's in the U.S.B. 10-year U.S. Treasury interest rates since 1979 have been managed by the Federal Reserve such that the rates vary by less than 50 basis points in any given year.C. The Bretton Woods accord has reduced exchange rate volatility between the U.S. dollar and the U.K. pound since it was passed in 1993.D. Both U.S. inflation rates and exchange rates are more volatile now than they were 50 years ago.E. Oil prices have tended to stabilize over the past twenty years.

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15. A strong argument can be made that the collapse of the savings and loan industry began when: A. the inflation rates in the U.S. began rising rapidly.B. the volatility of interest rates increased significantly.C. fluctuating commodity prices became the norm.D. the Bretton Woods accord became effective.E. the Federal Reserve began controlling the market rate of interest.

16. The breakdown of the Bretton Woods accord caused _____ volatility to increase. A. interest rateB. inflation rateC. exchange rateD. commodity priceE. option price

17. Which one of the following can a firm do if it effectively manages its financial risks? A. eliminate all the risks faced by the firmB. totally eliminate all financial risksC. reduce the price volatility it facesD. guarantee the firm's financial successE. avoid all long-term financial risks

18. A hedge between which two of the following firms is most apt to reduce each firm's financial risk exposure? A. wheat farmer and bakeryB. oil producer and coal minerC. wheat grower and pharmaceutical firmD. pastry bakery and cotton farmerE. shoe manufacturer and coat manufacturer

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19. Which one of the following statements is correct in relation to a firm's short-run financial risk? A. Short-run financial risk results from permanent changes in prices due to new technology.B. A financially sound firm can become financially distressed as the result of its short-run exposure to financial risk.C. Each segment of a business should be responsible for hedging its own short-run financial risk.D. Short-run financial risk is defined as temporary price changes which result directly from natural disasters, such as tornadoes, droughts, and floods.E. Thus far, hedging techniques have been unsuccessful in reducing short-run financial risk.

20. Long-run financial risk: A. can frequently be hedged on a permanent basis.B. is best hedged on a division by division basis within a conglomerate.C. is related more to near-term transactions than to advancements in technology.D. generally results from changes in the underlying economics of a business.E. can generally be hedged such that the financial viability of a firm is protected.

21. By hedging financial risk, a firm can: A. ensure a steady rate of return for its shareholders.B. eliminate price changes over the long-term.C. ensure its own economic viability.D. gain time to adapt to changing market conditions.E. eliminate its exposure to price increases in raw materials.

22. The seller of a forward contract: A. is obligated to make delivery and accept the forward price.B. has the option of making delivery and receiving the greater of the spot price or the contract price.C. has the option of either making delivery or accepting delivery.D. is obligated to take delivery and pays the lower of the spot market price or the contract price.E. is obligated to take delivery and pay the forward price.

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23. A bakery generally enters into a forward contract in wheat as a: A. hedger.B. speculator.C. spot trader.D. broker.E. spectator.

24. A forward contract: A. requires that payment be made in full when the contract is originated.B. provides the buyer with an option to buy an asset on the settlement date at the forward price.C. is a binding agreement on both the buyer and the seller and nets out as a zero sum game.D. is marked to the market daily at the seller's request.E. allows for immediate delivery at an agreed upon price which is to be paid on the settlement date.

25. Which one of the following is true regarding forward contracts? A. The upfront costs to enter a forward contract can be significant.B. If a buyer of a forward contract earns a $200 profit then the seller will also profit by $200.C. The buyer wins when market prices are less than the forward price.D. The payoff profile for the buyer of a forward contract is an upward sloping linear function.E. If the seller of a forward contract earns a profit then the buyer has neither a profit nor a loss.

26. A payoff profile: A. determines the price of an option contract.B. determines whether a forward or a futures contract is needed.C. applies only to contract sellers.D. determines the price of a collar.E. illustrates potential gains and losses.

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27. Futures contracts: A. are identical to forward contracts except for the size of the contract.B. provides an option to purchase an asset at a specified price on the settlement date.C. are marked to the market on a daily basis.D. cannot be resold.E. are limited to contracts on financial assets.

28. Which of the following are futures exchanges?I. New York Mercantile ExchangeII. New York Stock ExchangeIII. Chicago Board of TradeIV. NASDAQ A. I and II onlyB. II and III onlyC. II and IV onlyD. I and III onlyE. II, III, and IV only

29. Given the following information, what is the price per troy ounce that will be used for today's marking-to-market for the December silver contract?

Silver - 5,000 troy oz.: dollars and cents per troy oz.

A. $9.53B. $9.60C. $10.185D. $10.190E. $10.220

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30. What was the highest price per troy ounce for the December silver futures contract today?


A. $10.185B. $10.225C. $10.250D. $10.814E. $10.830

31. Browning Enterprises currently has all fixed-rate debt. The firm would like to convert part of this to floating-rate debt. Which one of the following will accomplish this for the firm? A. option on floating-rate bondsB. forward contract on U.S. Treasury billsC. interest rate swapD. currency swapE. interest rate call option

32. Which one of the following is the primary difference between a swap contract and a forward contract? A. underlying assetB. number of exchangesC. daily marking to the marketD. option versus obligationE. time of payment

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33. Interest rate swaps:I. benefit either the buyer or the seller, but not both.II. are often used in conjunction with a currency swap.III. are commonly used in business.IV. can be used to change the index which determines the variable rate on a firm's debt. A. I and III onlyB. II and IV onlyC. II, III, and IV onlyD. I, III, and IV onlyE. I, II, III, and IV

34. Which one of the following methods of setting prices would reduce the transactions exposure for both the buyer and seller of a swap contract? A. setting a permanent price at which a commodity will be tradedB. setting the price at the minimum spot price during a given period of timeC. setting the price equal to the spot price on the delivery dateD. using the average market price over a given period of timeE. setting the contract price equal to some percentage, less than 100 percent, of the market price on any given day

35. A swap dealer in the U.S.: A. acts solely as a seller of swap contracts.B. matches buyers to sellers.C. only deals if its book is matched.D. is frequently a commercial bank.E. trades electronically via NASDAQ.

36. Company A can borrow money at a fixed rate of 7.5 percent or a variable rate set at prime plus 0.5 percent. Company B can borrow money at a variable rate of prime plus 1 percent or a fixed rate of 7 percent. Company A prefers a fixed rate and company B prefers a variable rate. Given this information, which one of the following statements is correct? A. Company A can swap with B and pay a fixed rate of 7.25 percent.B. If Company A swaps with B, Company A could pay a fixed rate of 6.5 percent.C. If Company B swaps with A, Company B must pay a fixed rate of 8 percent.D. Company B can swap with A such that Company B pays the variable prime rate.E. There are no terms under which both Company A and Company B can swap interest rates and both realize a profit.

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37. Dog's can borrow money at either a fixed rate of 8.25 percent or a variable rate set at prime plus 0.5 percent. Cat's can borrow money at either a variable rate of prime plus 1 percent or a fixed rate of 8 percent. Dog's prefers a fixed rate and Cat's prefers a variable rate. Given this information, which one of the following statements is correct? A. After a swap with Cat's, Dog's could end up paying a fixed rate of 7.8 percent.B. Cat's should end up paying the prime rate if it agrees to an interest rate swap with Dog's.C. Both firms will profit if they swap an 8.15 percent fixed rate for a prime plus 0.75 percent variable rate.D. Dog's will end up paying no more than 7.75 percent as a fixed rate after a swap with Cat's.E. Dog's and Cat's cannot swap interest rates in a manner that will be profitable for both firms.

38. Murray's can borrow money at a fixed rate of 10.5 percent or a variable rate set at prime plus 2.25 percent. Fred's can borrow money at a variable rate of prime plus 1.5 percent or a fixed rate of 12 percent. Murray's prefers a variable rate and Fred's prefers a fixed rate. Given this information, which one of the following statements is correct? A. After swapping interest rates with Fred's, Murray's may be able to pay prime plus 2 percent.B. Both companies can profit in a swap which will allow Murray's to pay a variable rate of prime plus one percent.C. Fred's will end up with a fixed rate of 10 percent.D. Fred's has the best chance of profiting if it does an interest rate swap with Murray's.E. There are no terms under which Murray's and Fred's can swap interest rates.

39. A call option contract: A. obligates both the buyer and the seller.B. obligates the buyer but not the seller.C. grants rights to the buyer and obligates the seller.D. grants rights to the seller and obligates the buyer.E. grants rights to both the buyer and the seller but does not obligate either party.

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40. The buyer of an option contract: A. receives the option premium in exchange for an obligation to either buy or sell an underlying asset.B. pays an option premium in exchange for a right to buy or sell an underlying asset during a specified period of time.C. pays the strike price at the time the option is purchased and in exchange receives the right to exercise the option at any time during the option period.D. receives the option premium in exchange for guaranteeing the purchase or sale of an underlying asset if called upon to do so.E. pays the option premium in exchange for receiving the strike price at a later date.

41. An option contract:I. can be used to hedge risk.II. can be used to speculate in the market.III. can be based on a futures contract to create a futures option.IV. cannot be based on a foreign currency. A. II and III onlyB. I and II onlyC. I, II, and III onlyD. II, III, and IV onlyE. I, II, III, and IV

42. Which two of the following are key differences between an option contract and a forward contract?I. option contracts can be resold but forward contracts cannotII. the option price is determined at settlement while the forward price is determined when the contract is initiatedIII. the rights and obligations of the buyerIV. cost when contract initiated A. I and III onlyB. II and IV onlyC. III and IV onlyD. I and II onlyE. II and III only

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43. A firm with a variable-rate loan wants to protect itself from increases in interest rates. Which of the following would interest this firm?I. interest rate floorII. interest rate capIII. put option on an interest rateIV. call option on an interest rate A. I onlyB. I and III onlyC. I and IV onlyD. II and III onlyE. II and IV only

44. If a firm creates an interest rate collar on a variable rate loan, then the rate the firm pays will always: A. remain constant at the average of the floor and cap rates.B. remain constant at the floor rate.C. remain constant at the cap rate.D. be higher than, or equal to, the cap but lower than, or equal to, the floor.E. be higher than, or equal to, the floor but lower than, or equal to, the cap.

45. Which one of the following actions will provide you with the right, but not the obligation, to sell the underlying asset at a specified price during a specified period of time? A. purchase of a call optionB. sale of a call optionC. purchase of a put optionD. sale of a put optionE. swap

46. Which one of the following obligates you only on the expiration date to sell an asset at the strike price if the option is exercised? A. American callB. American putC. European callD. European putE. European swap

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47. Which one of the following statements concerning option payoffs is correct? A. The buyer of a call profits when the exercise price exceeds the market price.B. The buyer of a call profits when the strike price exceeds the exercise price.C. A put will only be exercised if both the seller and the buyer can profit.D. Both the buyer and the seller profit when a call is exercised.E. The seller of a put incurs a loss when a put is exercised.

48. You believe the price of a stock is going to decline within the next three months. Which one of the following option payoff profiles will reflect a profit if your belief is correct? A. buying a callB. selling a callC. buying a putD. selling a putE. none of the above

49. You own shares of a stock and believe the stock price will increase in the future. However, you realize the stock price could decline and want to hedge that risk. Which one of the following option positions should you take to create the desired hedge? A. buy a callB. sell a callC. buy a putD. sell a putE. none of the above

50. Most of the evidence to date indicates that firms with which two of the following characteristics are most apt to frequently use derivatives? I. firms with low financial distress costsII. firms with high financial distress costsIII. firms with easy access to capital marketsIV. firms with constrained access to capital markets A. I and III onlyB. I and IV onlyC. II and III onlyD. II and IV onlyE. III and IV only

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51. What is the closing value on this day for one March futures contract on silver?

Silver - 5,000 troy oz.: U.S. dollars and cents per troy oz.

A. $47,650B. $48,000C. $50,950D. $51,220E. $51,250

52. You own three January futures contracts on gold. What is the total value of your position as of the end of this day's trading?

Gold - 100 troy oz.: U.S. dollars and cents per troy oz.

A. $66,050B. $66,740C. $66,820D. $198,150E. $200,460

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53. What is the closing value on this day for one March futures contract on ethanol?

Ethanol - 29,000 U.S. gallons: U.S. dollars and cents per gallon

A. $49,300B. $49,387C. $49,416D. $1.703 millionE. $1.704 million

54. You purchased two May futures contracts on silver when the price quote was 10.420. Given today's closing prices as shown in the table, your total profit or loss to date is:


A. -$7,000B. -$3,500C. -$700D. -$350E. $70

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55. You purchased four April futures contracts on gold when the price quote was 687.7. Given today's closing prices as shown in the table, what is your current profit or loss?


A. $16,600B. $18,120C. $20,800D. $23,680E. $26,080

56. You decided to speculate in the market and sold 8 gold futures contracts when the futures price was $867.50 per ounce. The price on the contract maturity date was $730.40. What was your total profit or loss if the contract size was 100 ounces? A. -$109,680B. -$13,710C. $13,710D. $54,840E. $109,680

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57. You expect to deliver 40,000 bushels of wheat to the market in July. Today, you hedge your position by selling futures contracts on half of your expected delivery at the final price of the day. Assume that the market price turns out to be 582.0 when you actually deliver the wheat. How much more or less would you have earned if you had not bought the futures contracts?

Wheat - 5,000 bu.: U.S. cents per bu.

A. $8,000 lessB. $4,000 lessC. neither more nor lessD. $4,000 moreE. $8,000 more

58. You are the buyer for a cereal company and you must buy 80,000 bushels of corn next month. The futures contracts on corn are based on 5,000 bushels and are currently quoted at 4150 cents per bushel for delivery next month. If you want to hedge your cost, you should _____ contracts at a cost of _____ per contract. A. buy 12; $2,075B. buy 16; $20,750C. buy 16; $2,075,000D. sell 12; $2,075E. sell 16; $2,075,000

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59. You are a jewelry maker. In May of each year, you purchase 10,000 troy ounces of silver to restock your production inventory. Today, you hedged your position at what turned out to be the lowest price of the day. Assume the actual price per troy ounce of silver is 9.215 in May. How much did you gain or lose by hedging your position?


A. loss $4,400B. loss $2,200C. no gain or lossD. gain $2,200E. gain $4,400

60. You are the purchasing agent for a major cookie company. You anticipate that your firm will need 20,000 bushels of oats in December. You decide to hedge your position today and did so at the closing price of the day. Assume that the actual market price turns out to be 228.0 on the day you actually buy the oats. How much did you gain or lose by hedging your position?

Oats - 5,000 bu.: cents per bu.

A. lost $4,000B. lost $400C. saved $40D. saved $400E. saved $4,000

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61. How much will you pay per pound for a September 130 orange juice futures call option?

Orange juice - 15,000 lbs: U.S. cents per lb.

A. $0.0045B. $0.0065C. $0.0450D. $0.0650E. $0.1135

62. How much will you pay to purchase five August 125 orange juice futures put option contracts?


A. $1,200.00B. $2,362.50C. $4,162.50D. $6,637.50E. $6,750.00

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Essay Questions

63. What are the primary motives for a hedger and a speculator in the derivatives market? If a wheat farmer sells wheat futures, is that hedging or speculating? Explain.

64. Explain how a manufacturer who has an ongoing need for silver as a raw material in the production process might use futures to hedge. What does the manufacturer hope to gain?

65. What is cross-hedging? Why do you suppose firms use this method of risk management? What are some of the drawbacks?

66. Explain why a swap is effectively a series of forward contracts.

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67. Explain both the concept of financial engineering and why it is becoming increasingly popular in today's business environment.


68. Suppose you purchase a September cocoa futures contract at the last price of the day as shown in the table below. What will be your profit or loss on this contract if the price turns out to be $1,707 per metric ton at expiration?

Futures:Cocoa - 10 metric tons, $ per ton

A. $30B. $110C. $150D. $1,100E. $1,500

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69. Suppose you sell nine September silver futures contracts at the last price of the day as shown in the table below. What will be your profit or loss on this contract if the price turns out to be $12.09 per ounce at expiration?

Futures:Silver - 5,000 troy oz, U.S. cents per troy oz.

A. loss of $27,225B. loss of $7,050C. loss of $3,025D. profit of $3,025E. profit of $27,225

70. Suppose you purchase the November call option on orange juice futures with a strike price of 150 at the price shown in the table below. What will be your profit or loss on this contract if the price of orange juice futures is $0.616 per pound at expiration of the option contract?

Futures OptionsOrange juice: 15,000 lbs, U.S. cents per lb.

A. loss of $2,107.50B. loss of $1,717.50C. no profit or lossD. profit of $1,717.50E. profit of $2,107.50

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71. Suppose a financial manager buys call options on 45,000 barrels of oil with an exercise price of $30 per barrel. She simultaneously sells a put option on 45,000 barrels of oil with the same exercise price of $30 per barrel. Her net profit per barrel is _____ if the price per barrel is $29 and _____ if the price per barrel is $35. A. -$5; $1B. -$1; $0C. $0; -$1D. $0; $1E. -$1; $5

72. Suppose your firm produces breakfast cereal and needs 65,000 bushels of corn in December for an upcoming promotion. You would like to lock in your costs today because you are concerned that corn prices might go up between now and December. To hedge your risk exposure, you could purchase corn futures contracts today effectively locking in a total settlement price of _____, based on the closing price shown in the table below.

Futures:Corn - 5,000 bu., U.S. cents per bu.

A. $163,800B. $164,125C. $174,238D. $179,400E. $183,463

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Chapter 23 Risk Management: An Introduction to Financial Engineering Answer Key


1. Farmer Jones raises several hundred acres of corn and would suffer a significant loss should the price of corn decline at harvest time. Which one of the following would he be doing if he purchased financial securities to offset this price risk? A. abatingB. derivingC. hedgingD. forwardingE. manipulating

Refer to section 23.1

AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Hedging

2. The value of a stock option is dependent upon the value of the underlying stock. Thus, a stock option is a: A. forward agreement.B. derivative security.C. mezzanine asset.D. contingent security.E. junior security.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Derivative security

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3. Farmer Mac owns a large orange grove in Florida. The value of his business is directly related to the price of oranges. Which one of the following is a graphical representation of this price-value relationship? A. exchange lineB. net present value profileC. risk profileD. market lineE. return grid


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Risk profile

4. Farmer Ted planted 200 acres in wheat this year. The weather has been perfect and he expects to harvest a record crop within the next two weeks. At present, he has no storage facilities and therefore must sell his crop as soon as it is harvested. Which one of the following risks is he facing because he must sell his crop at whatever the market price is at harvest time? A. futures riskB. volatility exposureC. surplus riskD. transactions exposureE. translation exposure


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Transactions exposure

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5. For years, your family has operated a business that produces lawn mowers. Over the years, the industry has progressed and new mass production techniques have been developed. However, your firm cannot afford this new technology, nor can you compete against those firms that can. Thus, the family has decided to close its facility at the end of the year. Which one of the following describes the risks to which your family's firm succumbed? A. forward riskB. volatility exposureC. economic exposureD. transactions exposureE. translation risk


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Economic exposure

6. This morning a cereal maker agreed to pay a farmer $4.40 a bushel for 5,000 bushels of wheat that the farmer will ship to the factory four months from now. What is this legally binding agreement called? A. forward contractB. spot contractC. swapD. exchangeE. floating contract


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-2Section: 23.3Topic: Forward contract

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7. A graph depicting the gains and losses a seller of a forward contract would earn at various market prices is referred to as a: A. risk profile.B. payoff profile.C. risk offer line.D. scatter plot.E. risk-return graph.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-2Section: 23.3Topic: Payoff profile

8. By definition, which one of the following contracts is marked to the market on a daily basis? A. forward contractB. spot contractC. hedgeD. swapE. futures contract


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Futures contract

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9. Southern Groves raises tangerines. To hedge its risk, the firm trades in the orange futures market. This process is known as: A. secondary trading.B. open trading.C. open-hedging.D. cross-hedging.E. perfect-hedging.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Cross-hedging

10. The National Bank has an agreement with The Foreign Bank to exchange 500,000 U.S. dollars for 380,000 Euros on the first day of each of the next 3 calendar quarters. This agreement is best described as a(n): A. floating exchange.B. spot trade.C. option.D. futures contract.E. swap contract.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swap contract

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11. An agreement that grants its owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time is called a(n) _____ contract. A. optionB. forwardC. futuresD. swapE. spot


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Option contracts

12. Sue recently purchased a right to buy 100 shares of ABC stock for $27.50 a share if she so chooses at any time within the next four months. Which one of the following does Sue own? A. futures contractB. call optionC. put optionD. straddleE. strangle


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Call option

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13. Steve recently sold an option that requires him to purchase 100 shares of Omega stock at $40 a share should the option owner decide to exercise the option. What type of option contract did Steve sell? A. futures optionB. call optionC. put optionD. straddleE. strangle


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Put option

14. Which one of the following statements is correct? A. Price levels increased more in the late 1800's than they did in the late 1900's in the U.S.B. 10-year U.S. Treasury interest rates since 1979 have been managed by the Federal Reserve such that the rates vary by less than 50 basis points in any given year.C. The Bretton Woods accord has reduced exchange rate volatility between the U.S. dollar and the U.K. pound since it was passed in 1993.D. Both U.S. inflation rates and exchange rates are more volatile now than they were 50 years ago.E. Oil prices have tended to stabilize over the past twenty years.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Volatility

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15. A strong argument can be made that the collapse of the savings and loan industry began when: A. the inflation rates in the U.S. began rising rapidly.B. the volatility of interest rates increased significantly.C. fluctuating commodity prices became the norm.D. the Bretton Woods accord became effective.E. the Federal Reserve began controlling the market rate of interest.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Interest rate volatility

16. The breakdown of the Bretton Woods accord caused _____ volatility to increase. A. interest rateB. inflation rateC. exchange rateD. commodity priceE. option price


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Exchange rate volatility

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17. Which one of the following can a firm do if it effectively manages its financial risks? A. eliminate all the risks faced by the firmB. totally eliminate all financial risksC. reduce the price volatility it facesD. guarantee the firm's financial successE. avoid all long-term financial risks


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Financial risk management

18. A hedge between which two of the following firms is most apt to reduce each firm's financial risk exposure? A. wheat farmer and bakeryB. oil producer and coal minerC. wheat grower and pharmaceutical firmD. pastry bakery and cotton farmerE. shoe manufacturer and coat manufacturer


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Financial risk management

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19. Which one of the following statements is correct in relation to a firm's short-run financial risk? A. Short-run financial risk results from permanent changes in prices due to new technology.B. A financially sound firm can become financially distressed as the result of its short-run exposure to financial risk.C. Each segment of a business should be responsible for hedging its own short-run financial risk.D. Short-run financial risk is defined as temporary price changes which result directly from natural disasters, such as tornadoes, droughts, and floods.E. Thus far, hedging techniques have been unsuccessful in reducing short-run financial risk.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Short-run financial risk

20. Long-run financial risk: A. can frequently be hedged on a permanent basis.B. is best hedged on a division by division basis within a conglomerate.C. is related more to near-term transactions than to advancements in technology.D. generally results from changes in the underlying economics of a business.E. can generally be hedged such that the financial viability of a firm is protected.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Long-run financial risk

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21. By hedging financial risk, a firm can: A. ensure a steady rate of return for its shareholders.B. eliminate price changes over the long-term.C. ensure its own economic viability.D. gain time to adapt to changing market conditions.E. eliminate its exposure to price increases in raw materials.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-1Section: 23.2Topic: Hedging

22. The seller of a forward contract: A. is obligated to make delivery and accept the forward price.B. has the option of making delivery and receiving the greater of the spot price or the contract price.C. has the option of either making delivery or accepting delivery.D. is obligated to take delivery and pays the lower of the spot market price or the contract price.E. is obligated to take delivery and pay the forward price.



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23. A bakery generally enters into a forward contract in wheat as a: A. hedger.B. speculator.C. spot trader.D. broker.E. spectator.



24. A forward contract: A. requires that payment be made in full when the contract is originated.B. provides the buyer with an option to buy an asset on the settlement date at the forward price.C. is a binding agreement on both the buyer and the seller and nets out as a zero sum game.D. is marked to the market daily at the seller's request.E. allows for immediate delivery at an agreed upon price which is to be paid on the settlement date.



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25. Which one of the following is true regarding forward contracts? A. The upfront costs to enter a forward contract can be significant.B. If a buyer of a forward contract earns a $200 profit then the seller will also profit by $200.C. The buyer wins when market prices are less than the forward price.D. The payoff profile for the buyer of a forward contract is an upward sloping linear function.E. If the seller of a forward contract earns a profit then the buyer has neither a profit nor a loss.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-2Section: 23.3Topic: Forward contract

26. A payoff profile: A. determines the price of an option contract.B. determines whether a forward or a futures contract is needed.C. applies only to contract sellers.D. determines the price of a collar.E. illustrates potential gains and losses.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-2Section: 23.3Topic: Payoff profile

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27. Futures contracts: A. are identical to forward contracts except for the size of the contract.B. provides an option to purchase an asset at a specified price on the settlement date.C. are marked to the market on a daily basis.D. cannot be resold.E. are limited to contracts on financial assets.



28. Which of the following are futures exchanges?I. New York Mercantile ExchangeII. New York Stock ExchangeIII. Chicago Board of TradeIV. NASDAQ A. I and II onlyB. II and III onlyC. II and IV onlyD. I and III onlyE. II, III, and IV only



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29. Given the following information, what is the price per troy ounce that will be used for today's marking-to-market for the December silver contract?


A. $9.53B. $9.60C. $10.185D. $10.190E. $10.220


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Futures price

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30. What was the highest price per troy ounce for the December silver futures contract today?


A. $10.185B. $10.225C. $10.250D. $10.814E. $10.830


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Futures price

31. Browning Enterprises currently has all fixed-rate debt. The firm would like to convert part of this to floating-rate debt. Which one of the following will accomplish this for the firm? A. option on floating-rate bondsB. forward contract on U.S. Treasury billsC. interest rate swapD. currency swapE. interest rate call option


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swap contract

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32. Which one of the following is the primary difference between a swap contract and a forward contract? A. underlying assetB. number of exchangesC. daily marking to the marketD. option versus obligationE. time of payment


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swap contract

33. Interest rate swaps:I. benefit either the buyer or the seller, but not both.II. are often used in conjunction with a currency swap.III. are commonly used in business.IV. can be used to change the index which determines the variable rate on a firm's debt. A. I and III onlyB. II and IV onlyC. II, III, and IV onlyD. I, III, and IV onlyE. I, II, III, and IV


AACSB: N/ABloom's: ComprehensionDifficulty: IntermediateLearning Objective: 23-3Section: 23.5Topic: Interest rate swap

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34. Which one of the following methods of setting prices would reduce the transactions exposure for both the buyer and seller of a swap contract? A. setting a permanent price at which a commodity will be tradedB. setting the price at the minimum spot price during a given period of timeC. setting the price equal to the spot price on the delivery dateD. using the average market price over a given period of timeE. setting the contract price equal to some percentage, less than 100 percent, of the market price on any given day


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swap contract

35. A swap dealer in the U.S.: A. acts solely as a seller of swap contracts.B. matches buyers to sellers.C. only deals if its book is matched.D. is frequently a commercial bank.E. trades electronically via NASDAQ.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swap dealer

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36. Company A can borrow money at a fixed rate of 7.5 percent or a variable rate set at prime plus 0.5 percent. Company B can borrow money at a variable rate of prime plus 1 percent or a fixed rate of 7 percent. Company A prefers a fixed rate and company B prefers a variable rate. Given this information, which one of the following statements is correct? A. Company A can swap with B and pay a fixed rate of 7.25 percent.B. If Company A swaps with B, Company A could pay a fixed rate of 6.5 percent.C. If Company B swaps with A, Company B must pay a fixed rate of 8 percent.D. Company B can swap with A such that Company B pays the variable prime rate.E. There are no terms under which both Company A and Company B can swap interest rates and both realize a profit.


AACSB: N/ABloom's: AnalysisDifficulty: IntermediateLearning Objective: 23-3Section: 23.5Topic: Interest rate swap

37. Dog's can borrow money at either a fixed rate of 8.25 percent or a variable rate set at prime plus 0.5 percent. Cat's can borrow money at either a variable rate of prime plus 1 percent or a fixed rate of 8 percent. Dog's prefers a fixed rate and Cat's prefers a variable rate. Given this information, which one of the following statements is correct? A. After a swap with Cat's, Dog's could end up paying a fixed rate of 7.8 percent.B. Cat's should end up paying the prime rate if it agrees to an interest rate swap with Dog's.C. Both firms will profit if they swap an 8.15 percent fixed rate for a prime plus 0.75 percent variable rate.D. Dog's will end up paying no more than 7.75 percent as a fixed rate after a swap with Cat's.E. Dog's and Cat's cannot swap interest rates in a manner that will be profitable for both firms.



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38. Murray's can borrow money at a fixed rate of 10.5 percent or a variable rate set at prime plus 2.25 percent. Fred's can borrow money at a variable rate of prime plus 1.5 percent or a fixed rate of 12 percent. Murray's prefers a variable rate and Fred's prefers a fixed rate. Given this information, which one of the following statements is correct? A. After swapping interest rates with Fred's, Murray's may be able to pay prime plus 2 percent.B. Both companies can profit in a swap which will allow Murray's to pay a variable rate of prime plus one percent.C. Fred's will end up with a fixed rate of 10 percent.D. Fred's has the best chance of profiting if it does an interest rate swap with Murray's.E. There are no terms under which Murray's and Fred's can swap interest rates.



39. A call option contract: A. obligates both the buyer and the seller.B. obligates the buyer but not the seller.C. grants rights to the buyer and obligates the seller.D. grants rights to the seller and obligates the buyer.E. grants rights to both the buyer and the seller but does not obligate either party.



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40. The buyer of an option contract: A. receives the option premium in exchange for an obligation to either buy or sell an underlying asset.B. pays an option premium in exchange for a right to buy or sell an underlying asset during a specified period of time.C. pays the strike price at the time the option is purchased and in exchange receives the right to exercise the option at any time during the option period.D. receives the option premium in exchange for guaranteeing the purchase or sale of an underlying asset if called upon to do so.E. pays the option premium in exchange for receiving the strike price at a later date.



41. An option contract:I. can be used to hedge risk.II. can be used to speculate in the market.III. can be based on a futures contract to create a futures option.IV. cannot be based on a foreign currency. A. II and III onlyB. I and II onlyC. I, II, and III onlyD. II, III, and IV onlyE. I, II, III, and IV


AACSB: N/ABloom's: KnowledgeDifficulty: IntermediateLearning Objective: 23-4Section: 23.6Topic: Option contracts

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42. Which two of the following are key differences between an option contract and a forward contract?I. option contracts can be resold but forward contracts cannotII. the option price is determined at settlement while the forward price is determined when the contract is initiatedIII. the rights and obligations of the buyerIV. cost when contract initiated A. I and III onlyB. II and IV onlyC. III and IV onlyD. I and II onlyE. II and III only

Refer to sections 23.3 and 23.6

AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-2 and 23-4Section: 23.3 and 23.6Topic: Option and forward contracts

43. A firm with a variable-rate loan wants to protect itself from increases in interest rates. Which of the following would interest this firm?I. interest rate floorII. interest rate capIII. put option on an interest rateIV. call option on an interest rate A. I onlyB. I and III onlyC. I and IV onlyD. II and III onlyE. II and IV only



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44. If a firm creates an interest rate collar on a variable rate loan, then the rate the firm pays will always: A. remain constant at the average of the floor and cap rates.B. remain constant at the floor rate.C. remain constant at the cap rate.D. be higher than, or equal to, the cap but lower than, or equal to, the floor.E. be higher than, or equal to, the floor but lower than, or equal to, the cap.


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Interest rate collar

45. Which one of the following actions will provide you with the right, but not the obligation, to sell the underlying asset at a specified price during a specified period of time? A. purchase of a call optionB. sale of a call optionC. purchase of a put optionD. sale of a put optionE. swap



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46. Which one of the following obligates you only on the expiration date to sell an asset at the strike price if the option is exercised? A. American callB. American putC. European callD. European putE. European swap



47. Which one of the following statements concerning option payoffs is correct? A. The buyer of a call profits when the exercise price exceeds the market price.B. The buyer of a call profits when the strike price exceeds the exercise price.C. A put will only be exercised if both the seller and the buyer can profit.D. Both the buyer and the seller profit when a call is exercised.E. The seller of a put incurs a loss when a put is exercised.


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Option payoff

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48. You believe the price of a stock is going to decline within the next three months. Which one of the following option payoff profiles will reflect a profit if your belief is correct? A. buying a callB. selling a callC. buying a putD. selling a putE. none of the above


AACSB: N/ABloom's: ComprehensionDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Option payoff

49. You own shares of a stock and believe the stock price will increase in the future. However, you realize the stock price could decline and want to hedge that risk. Which one of the following option positions should you take to create the desired hedge? A. buy a callB. sell a callC. buy a putD. sell a putE. none of the above


AACSB: N/ABloom's: AnalysisDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Option payoff

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50. Most of the evidence to date indicates that firms with which two of the following characteristics are most apt to frequently use derivatives? I. firms with low financial distress costsII. firms with high financial distress costsIII. firms with easy access to capital marketsIV. firms with constrained access to capital markets A. I and III onlyB. I and IV onlyC. II and III onlyD. II and IV onlyE. III and IV only


AACSB: N/ABloom's: KnowledgeDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Derivatives use

51. What is the closing value on this day for one March futures contract on silver?


A. $47,650B. $48,000C. $50,950D. $51,220E. $51,250

Closing value = $10.244 5,000 = $51,220

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Contract value

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52. You own three January futures contracts on gold. What is the total value of your position as of the end of this day's trading?


A. $66,050B. $66,740C. $66,820D. $198,150E. $200,460

Position value = 3 100 $660.50 = $198,150


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53. What is the closing value on this day for one March futures contract on ethanol?

Ethanol - 29,000 U.S. gallons: U.S. dollars and cents per gallon

A. $49,300B. $49,387C. $49,416D. $1.703 millionE. $1.704 million

Contract value = 29,000 $1.703 = $49,387


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54. You purchased two May futures contracts on silver when the price quote was 10.420. Given today's closing prices as shown in the table, your total profit or loss to date is:


A. -$7,000B. -$3,500C. -$700D. -$350E. $70

Total loss to date = 2 5,000 ($9.720 - $10.420) = -$7,000

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateLearning Objective: 23-2Section: 23.4Topic: Contract profit

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55. You purchased four April futures contracts on gold when the price quote was 687.7. Given today's closing prices as shown in the table, what is your current profit or loss?


A. $16,600B. $18,120C. $20,800D. $23,680E. $26,080

Total profit to date = 4 100 ($733 - $687.70) = $18,120


56. You decided to speculate in the market and sold 8 gold futures contracts when the futures price was $867.50 per ounce. The price on the contract maturity date was $730.40. What was your total profit or loss if the contract size was 100 ounces? A. -$109,680B. -$13,710C. $13,710D. $54,840E. $109,680

Total loss = 8 100 ($867.50 - $730.40) = $109,680


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57. You expect to deliver 40,000 bushels of wheat to the market in July. Today, you hedge your position by selling futures contracts on half of your expected delivery at the final price of the day. Assume that the market price turns out to be 582.0 when you actually deliver the wheat. How much more or less would you have earned if you had not bought the futures contracts?

Wheat - 5,000 bu.: U.S. cents per bu.

A. $8,000 lessB. $4,000 lessC. neither more nor lessD. $4,000 moreE. $8,000 more

Loss on contract = (0.5 40,000) [(582.0 - 562.0)/100] = $4,000. You would have received $4,000 more if you had not sold the futures contract.

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateLearning Objective: 23-2Section: 23.4Topic: Futures hedge

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58. You are the buyer for a cereal company and you must buy 80,000 bushels of corn next month. The futures contracts on corn are based on 5,000 bushels and are currently quoted at 4150 cents per bushel for delivery next month. If you want to hedge your cost, you should _____ contracts at a cost of _____ per contract. A. buy 12; $2,075B. buy 16; $20,750C. buy 16; $2,075,000D. sell 12; $2,075E. sell 16; $2,075,000

Number of contracts = 80,000/5,000 = 16 contractsContract value = 5,000 (415.0/100) = $20,750.You should buy 16 contracts at $20,750 per contract.

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 23-2Section: 23.4Topic: Futures hedge

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59. You are a jewelry maker. In May of each year, you purchase 10,000 troy ounces of silver to restock your production inventory. Today, you hedged your position at what turned out to be the lowest price of the day. Assume the actual price per troy ounce of silver is 9.215 in May. How much did you gain or lose by hedging your position?


A. loss $4,400B. loss $2,200C. no gain or lossD. gain $2,200E. gain $4,400

Savings = 2 5,000 ($9.215 - $9.655) = -$4,400. You lost $4,400 by hedging.


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60. You are the purchasing agent for a major cookie company. You anticipate that your firm will need 20,000 bushels of oats in December. You decide to hedge your position today and did so at the closing price of the day. Assume that the actual market price turns out to be 228.0 on the day you actually buy the oats. How much did you gain or lose by hedging your position?

Oats - 5,000 bu.: cents per bu.

A. lost $4,000B. lost $400C. saved $40D. saved $400E. saved $4,000

Savings = 4 5,000 [(228 - 230)/100] = -$400You lost $400 by hedging.


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61. How much will you pay per pound for a September 130 orange juice futures call option?


A. $0.0045B. $0.0065C. $0.0450D. $0.0650E. $0.1135

Cost per pound = $0.045

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Futures options

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62. How much will you pay to purchase five August 125 orange juice futures put option contracts?


A. $1,200.00B. $2,362.50C. $4,162.50D. $6,637.50E. $6,750.00

Total cost = 5 15,000 (5.55/100) = $4,162.50

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicLearning Objective: 23-4Section: 23.6Topic: Futures options

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Essay Questions

63. What are the primary motives for a hedger and a speculator in the derivatives market? If a wheat farmer sells wheat futures, is that hedging or speculating? Explain.

The key is whether or not the contracting party has an existing position in the underlying asset. The farmer can be both a hedger and a speculator depending upon the quantity of wheat produced versus the quantity of wheat futures sold. Good students will recognize that hedgers contract in order to reduce risk while speculators seek risk with the expectation of earning sizeable returns.

Feedback: Refer to section 23.4

AACSB: Reflective thinkingBloom's: ComprehensionDifficulty: IntermediateLearning Objective: 23-2Section: 23.4Topic: Hedgers and speculators

64. Explain how a manufacturer who has an ongoing need for silver as a raw material in the production process might use futures to hedge. What does the manufacturer hope to gain?

The manufacturer needs to acquire silver so will purchase silver futures to offset higher production costs should silver prices rise in the spot commodity market. Since there is an ongoing need, it is likely the manufacturer will maintain a continuous position in the silver futures market. The firm in this case hopes to insulate itself from fluctuations in the price of silver, thereby maintaining a more predictable stream of production cost cash outflows.


AACSB: Reflective thinkingBloom's: ApplicationDifficulty: IntermediateLearning Objective: 23-2Section: 23.4Topic: Hedging with futures

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65. What is cross-hedging? Why do you suppose firms use this method of risk management? What are some of the drawbacks?

Cross-hedging is hedging an asset with contracts written on a closely related, but not identical, asset. Firms engage in cross-hedging because they cannot find a perfect match for the commodity or financial asset they are seeking to manage. The source of the imperfect match could be grading, timing, or quantity mismatches, or one of several other factors. The primary drawback of a cross-hedge is the fact that not all of the firm's risk will be eliminated since, by definition, a cross-hedge is an imperfect match.


AACSB: Reflective thinkingBloom's: AnalysisDifficulty: IntermediateLearning Objective: 23-1Section: 23.4Topic: Cross-hedging

66. Explain why a swap is effectively a series of forward contracts.

In a forward contract, the parties agree at the outset to a specified transaction at some point in the future at a predetermined price. In a swap, the parties agree to several future transactions at predetermined prices. Thus, each transaction specified by the swap contract is essentially a forward contract.


AACSB: Reflective thinkingBloom's: ComprehensionDifficulty: BasicLearning Objective: 23-3Section: 23.5Topic: Swaps and forwards

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67. Explain both the concept of financial engineering and why it is becoming increasingly popular in today's business environment.

Financial engineering is the creation and use of derivative securities to hedge risk. It is becoming increasingly popular because of the increasing volatility and uncertainty surrounding prices, interest rates, and exchange rates.


AACSB: Reflective thinkingBloom's: ComprehensionDifficulty: BasicLearning Objective: 23-1Section: 23.1Topic: Financial engineering

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68. Suppose you purchase a September cocoa futures contract at the last price of the day as shown in the table below. What will be your profit or loss on this contract if the price turns out to be $1,707 per metric ton at expiration?

Futures:Cocoa - 10 metric tons, $ per ton

A. $30B. $110C. $150D. $1,100E. $1,500

Profit = 10 ($1,707 - $1,696) = $110

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 23-1Learning Objective: 23-2Section: 23.4Topic: Futures contract

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69. Suppose you sell nine September silver futures contracts at the last price of the day as shown in the table below. What will be your profit or loss on this contract if the price turns out to be $12.09 per ounce at expiration?

Futures:Silver - 5,000 troy oz, U.S. cents per troy oz.

A. loss of $27,225B. loss of $7,050C. loss of $3,025D. profit of $3,025E. profit of $27,225

Since you sold contracts, you have a short position and thus incur a loss when the price rises.Profit = 9 5,000 ($11.485 - $12.09) = -$27,225 (loss)

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 23-2Learning Objective: 23-2Section: 23.4Topic: Futures contract

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70. Suppose you purchase the November call option on orange juice futures with a strike price of 150 at the price shown in the table below. What will be your profit or loss on this contract if the price of orange juice futures is $0.616 per pound at expiration of the option contract?

Futures OptionsOrange juice: 15,000 lbs, U.S. cents per lb.

A. loss of $2,107.50B. loss of $1,717.50C. no profit or lossD. profit of $1,717.50E. profit of $2,107.50

The call will be out of the money at expiration.Loss = initial cost of contract = 15,000 (14.05/100) = $2,107.50

AACSB: AnalyticBloom's: ApplicationDifficulty: BasicEOC #: 23-3Learning Objective: 23-4Section: 23.6Topic: Futures options

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71. Suppose a financial manager buys call options on 45,000 barrels of oil with an exercise price of $30 per barrel. She simultaneously sells a put option on 45,000 barrels of oil with the same exercise price of $30 per barrel. Her net profit per barrel is _____ if the price per barrel is $29 and _____ if the price per barrel is $35. A. -$5; $1B. -$1; $0C. $0; -$1D. $0; $1E. -$1; $5

At $29: Value of call option position = $0; Value of put option position = -$1; Total = -$1At $35: Value of call option position = $5; Value of put option position = $0; Total = $5

AACSB: AnalyticBloom's: AnalysisDifficulty: BasicEOC #: 23-4Learning Objective: 23-4Section: 23.6Topic: Call and put payoffs

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72. Suppose your firm produces breakfast cereal and needs 65,000 bushels of corn in December for an upcoming promotion. You would like to lock in your costs today because you are concerned that corn prices might go up between now and December. To hedge your risk exposure, you could purchase corn futures contracts today effectively locking in a total settlement price of _____, based on the closing price shown in the table below.

Futures:Corn - 5,000 bu., U.S. cents per bu.

A. $163,800B. $164,125C. $174,238D. $179,400E. $183,463

Number of contracts needed = 65,000/5,000 = 13 contracts

AACSB: AnalyticBloom's: AnalysisDifficulty: IntermediateEOC #: 23-6Learning Objective: 23-2Section: 23.4Topic: Hedging with futures

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Chap023

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