Chapter 07 Testbank

Student: ___________________________________________________________________________
1.
A ... is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be exchanged for
cash at some later date.

A. call option
B. put option
C. forward contract
D. swap
2.
A ... is a (non-standard) contract between two parties to deliver and pay for an asset in the future.

A. call option
B. put option
C. forward contract
D. swap
3.
A ... is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

A. call option
B. put option
C. forward contract
D. futures contract
4.
Which of the following statements is true?

A. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each hour to
reflect current futures market conditions.
B. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each day to
reflect current futures market conditions.
C. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each week
to reflect current futures market conditions.
D. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each month
to reflect current futures market conditions.

5.
... is the process by which the prices on outstanding futures contracts are adjusted each day to reflect current futures market
conditions.

A. Hedging
B. Marking to market
C. Arbitrage
D. Securitisation
6.
Which of the following statements is true?

A. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a
dollar hedge.
B. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a plain
hedge.
C. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a
nave hedge.
D. All of the listed options are correct.
7.
In a 'plain Vanilla swap' the swap buyer agrees to make:

A. fixed-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the
use of derivatives to turn it into a fixed-rate loan
B. fixed-interest payments to the swap seller on a loan that is originally fixed, but which is then modified through the use
of derivatives to turn it into a floating-rate loan
C. floating-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the
use of derivatives to turn it into a fixed loan
D. None of the listed options are correct.
8.
Which of the following statements is true?

A.
B.
C.
D.

Using a futures or forward contract to hedge a specific asset or liability risk is called macrohedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called microhedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called asset- or liability-specific hedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called nave hedging.

9.
Which of the following statements is true?

A.
B.
C.
D.

Microhedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
Macrohedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
Microhedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.
Macrohedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.

10.
Which of the following statements is true?

A.
B.
C.
D.

Routine hedging seeks to hedge all interest rate risk exposure.

Routine hedging seeks to hedge all foreign exchange rate risk exposure.
Routine hedging seeks to hedge all liquidity risk exposure.
Routine hedging seeks to hedge all capital risk exposure.

11.
... is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the movement in
the price of the asset delivered under a futures or forward contract.

A. Macro risk
B. Micro risk
C. Basis risk
D. Duration risk
12.
Partially hedging the gap or individual assets and liabilities is referred to as?

A.
B.
C.
D.

hedging arbitrarily
hedging selectively
hedging partially
hedging naively

13.
The final settlement in which all bought and sold futures contracts in existence at the close of trading in the contract month are
settled at the cash settlement price is called a:

A.
B.
C.
D.

periodical cash settlement

mandatory cash settlement
monthly cash settlement
final cash settlement

14.
An undeliverable futures contract refers to a futures contract in which:

A.
B.
C.
D.

there is no physical settlement

there is no mandatory cash settlement
one of the parties is unable to deliver
money has been lost due to a party having chosen an unfavourable hedging strategy

15.
Which of the following is an adequate definition of conversion factor?

A. A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is
delivered to the buyer.
B. A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the buyer.
C. A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is
delivered to the seller.
D. A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the seller.
16.
Within the futures market, to be fully hedged means:

A. Buying a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
B. Selling a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
C. Selling a sufficient number of futures contracts so that the gain of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
D. None of the listed options are correct.
17.
The dollar value of the outstanding futures position depends on the:

A.
B.
C.
D.

number of contracts bought and sold and the price of each contract
cash exposure ratio
number of contracts bought and sold and the change in interest rates
contracts that should be sold per dollar of cash exposure

18.
Which of the following are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a prespecified price for a specified time period?

A.
B.
C.
D.

options
futures
forwards
swaps

19.
Which of the following statements is true?

A.
B.
C.
D.

In equity markets, delivery and cash settlement normally occur two business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur three business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur four business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur five business days after the spot agreement.

20.
Which of the following is a major difference between forwards and futures?

A. Forwards are marked to market, while futures are not.

B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked to market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.
21.
An Australian bank must pay US$10 million in 90 days. It wishes to hedge the risk in the futures market. To do so, the bank should:

A.
B.
C.
D.

buy A$10 million in US dollar futures

sell A$10 million in US dollar futures, with three-month maturity
buy US$10 million in US dollar futures
sell US$10 million in US dollar futures

22.
Which of the following is true of the market price of a futures contract over time?

A.
B.
C.
D.

It is set at time 0.
It is fixed over the life of the contract.
It changes based on the market value of the underlying asset.
It decreases with time to expiration.

23.
Which of the following statements is true?

A. In a spot contract the buyer and seller enter into a contract at time 0, the contract is marked to market, the seller
agrees on a price at time 0 and the bonds is delivered by the seller to the buyer 'at that time'.
B. In a spot contract the buyer and seller agree on a price at time 0 and the bonds is delivered by the seller at a future
point in time, for example, after three months.
C. In a spot contract the buyer and on a daily basis, and the buyer pays the spot price quoted at expiry.
D. None of the listed options are correct.
24.
Which of the following statements is true?

A. In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the
buyer 'at that time'.
B. In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a
future point in time, for example, after three months.
C. In a forward contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily
basis, and the buyer pays the forward price quoted at expiry.
D. None of the listed options are correct.
25.
Which of the following statements is true?

A. In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the
buyer 'at that time'.
B. In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a
future point in time, for example, after three months.
C. In a futures contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily
basis, and the buyer pays the futures price quoted at expiry.
D. None of the listed options are correct.
26.
Which of the following statements is true?

A. A very actively traded spot contract is the spot rate agreement (SRA).
B. A very actively traded spot contract is the futures rate agreement (FRA).
C. A very actively traded forward contract is the forward rate agreement (FRA), commonly used to lock in the interest rate
on shorter term borrowings.
D.
A very actively traded spot contract is the option rate agreement (ORA), commonly used to grant the right to buy or sell an asset at a
specified price.

27.
Which of the following is a common use of FRAs?

A.
B.
C.
D.

To lock in an interest rate on relatively shorter term borrowings.

To lock in an interest rate on medium-term borrowings.
To lock in an interest rate on relatively longer term borrowings.
To lock in an interest rate on any term of borrowings.

28.
Which of the following statements is true?

A. In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-market process.
B. In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-market process.
C. In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-book value process.
D. In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-book value process.
29.
A company is considering using futures contracts to hedge an identified interest rate exposure on its debt facilities. However, it is
concerned about the impact of basis risk. All of the following statements regarding basis risk are correct, except:

A. basis risk is the difference between prices in the physical market and the price of the relevant futures market contract.
B. the existence of basis risk removes the opportunity for a perfect borrowing hedge.
C. initial basis will be evident while the market is of the view that physical market prices will remain stable.
D. final basis will exist where a futures contract is used to hedge a risk associated with a different physical market
product.

30.
An FI portfolio manager holds 10-year $1 million face value bonds. At time 0, these bonds are valued at $95 per $100 of face value
and the manager expects interest rates to rise over the next three months. What should the manager do?

A. The FI portfolio manager should leave the position untouched as changes in the interest rate have no impact on bond
prices.
B. The FI portfolio manager should leave the position untouched as an increase in interest rates will lead to higher bond
prices.
C. The FI portfolio manager should hedge the position by selling a three months forward contract with a face value of $1
million.
D. The FI portfolio manager should hedge the position by buying a three months forward contract with a face value of $1
million.
31.
Assume that the price paid by the buyer of a forward is $82 000 and further assume that the spot price of purchasing the hedged
underlying asset at delivery date is $85 000. What is the result for the forward seller?

A.
B.
C.
D.

The result is a $3000 profit.

The result is a $3000 loss.
The answer depends on how the forward price develops over time.
There is too little information to answer the question.

32.
Financial futures are used by FIs to manage:

A.
B.
C.
D.

credit risk
interest rate risk
liquidity risk
sovereign country risk

33.
A forward contract:

A.
B.
C.
D.
E.

has more credit risk than a futures contract

is more standardised than a futures contract
is marked to market more frequently than a futures contract
has a shorter time to delivery than a futures contract
is less risky than a futures contract.

34.
The benefit of a futures exchange is:

A.
B.
C.
D.

elimination of customer risk exposure

provision of clearing services
guarantee of trading volume
intervention on the trader's behalf with government regulators

35.
In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities. In June, the
91-day Treasury bill rate is 5.50 per cent. What is the investor's profit (loss) if the 91-day rate falls to 5.20 per cent in September?

A.
B.
C.
D.

The investor loses $30 000 because of the 30 basis point decline in interest rates.
The investor gains $30 000 because of the 30 basis point decline in interest rates.
The investor gains $7583 because of the 30 basis point decline in interest rates.
The investor loses $7583 because of the 30 basis point decline in interest rates.

36.
In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities. In June, the
91-day Treasury bill rate is 5.50 per cent. If the investor uses 10 T-bill futures contracts to hedge the interest rate risk, should she
take a long or a short hedge? What are the returns on the futures hedge if there is no basis risk?

A.
B.
C.
D.

She earns $30 000 on the short futures hedge.

She earns $30 000 on the long futures hedge.
She earns $7500 on the short futures hedge.
She earns $7500 on the long futures hedge.

37.
Which of the following statements is true?

A. The advantage of using forwards for creating a synthetic fixed rate position is that there are no cash flows until the
contract matures.
B. The advantage of using futures for creating a synthetic fixed rate position is that futures contracts are standardised.
C. The advantage of using forwards for creating a synthetic fixed rate position is that futures contracts are standardised.
D.
The advantage of using futures for creating a synthetic fixed rate position is that there are no cash flows until the contract matures.

38.
Which of the following statements is true?

A. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called value risk.
B. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called basis risk.
C. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called gap risk.
D. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called fundamental risk.
39.
Which of the following statements is true?

A.
B.
C.
D.

Micro- and macrohedging always lead to the same hedging strategies and results.
Micro- and macrohedging can lead to the same hedging strategies but will lead to different results.
Micro- and macrohedging will lead to different hedging strategies but will also lead to the same results.
Micro- and macrohedging can lead to different hedging strategies and results.

40.
Which of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract?

A. Forward contracts are classified as exotic derivatives.

B. Margin requirements on futures.
C. More flexibility as the buyer can decide whether or not to exercise the contract at maturity.
D. None of the listed options are correct, as the default risk of a futures contract is generally considered to be higher than
that of a forward contract.
41.
Which of the following statements is true?

A. Over-hedging will lead to a significant reduction in risk, but also in returns.

B. In terms of risk and return, there is a linear relationship between an unhedged, a selectively hedged, a fully hedged
and an over-hedged position.
C. It is not possible to over-hedge a position.
D. Over-hedging will lead to a significant reduction in risk, but also in returns, in terms of risk and return, there is a linear
relationship between an unhedged, a selectively hedged, a fully hedged and an over-hedged position and it is not possible
to over-hedge a position.

42.
What is a swap?

A. An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a
specified interval.
B. An agreement between a buyer and a seller at time 0 to exchange a non-standardised asset for cash at some future
date.
C. A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price
within a specified period of time.
D. Trading in securities prior to their actual issue.
43.
Which of the following best describes a derivative contract?

A. Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B. Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C. Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified
date in the future.
D. Trading in securities prior to their actual issue.
44.
Which of the following statements is true?

A.
B.
C.
D.

In Australian interest rate futures there is no physical settlement of either 10-year or three-year bond futures.
In Australian interest rate futures there is no physical settlement of either 10-year or five-year bond futures.
In Australian interest rate futures there is no physical settlement of either five-year or three-year bond futures.
In Australian interest rate futures there is always physical settlement.

45.
In a put option on a bond, the:

A.
B.
C.
D.

seller of the put option is committed to receive the underlying bond at a specified time
buyer of the put option is committed to handing over the specified bond at a specified time to the seller of the option
buyer of the option is committed to receive the underlying bond at a specified time
seller of the bond is committed to handing over the specified bond at a specified time

46.
A major difference between a forward and a futures contract:

A.
B.
C.
D.

is the forward has less credit risk than a futures contract

is the forward contract is tailor-made to fit the needs of the buyer
is the forward contract is marked to market more frequently than a futures contract
is the forward contract rarely has final delivery of the asset

47.
A futures contract:

A.
B.
C.
D.

is tailor made to fit the needs of the buyer and the seller
has more price risk than a forward contract
is marked to market more frequently than a forward contract
has a shorter time to delivery than a forward contract

48.
An agreement between a buyer and a seller at time 0 where the seller of an asset agrees to deliver an asset immediately and the
buyer agrees to pay for the asset immediately is the characteristic of a:

A.
B.
C.
D.

spot contract
forward contract
futures contract
put options contract

49.
What is a difference between a forward contract and a future contract?

A. The settlement price of a forward contract is fixed over the life of the contract but in a futures contract is marked to
market daily.
B. Forward contracts are normally arranged through an organised exchange, while most futures contracts are OTC
contracts.
C. Both are essentially the same, except for the fact that the terms of a forward contract is set by the exchange, subject to
the approval of the SFE.
D. Delivery of the underlying asset almost always occurs on a futures contract but almost never occurs on a forward
contract.
50.
Which of the following is an example of microhedging asset-side portfolio risk?

A. When an FI, attempting to lock in cost of funds to protect itself against a rise in short-term interest rates, takes a short
position in futures contracts on CDs.
B. FI manager trying to pick a futures contract whose underlying deliverable asset is not matched to the asset position
being hedged.
C. When an FI hedges a cash asset on a direct dollar for dollar basis with a forward or futures contract.
D. When an FI manager wants to insulate the value of the institution's bond portfolio fully against a rise in interest rates.
51.
An FI has reduced its interest rate risk exposure to the lowest possible level by selling sufficient futures to offset the risk exposure of
its whole balance sheet or cash positions in each asset and liability. The FI is involved in:

A.
B.
C.
D.

microhedging
selective hedging
routine hedging
over-hedging

52.
The buyer of a bond call option:

A.
B.
C.
D.

receives a premium in return for standing ready to sell the bond at the exercise price
receives a premium in return for standing ready to buy bonds at the exercise price
pays a premium and has the right to sell the underlying bond at the agreed exercise price
pays a premium and has the right to buy the underlying bond at the agreed exercise price

53.
The writer of a bond call option:

A.
B.
C.
D.

receives a premium and must stand ready to sell the bond at the exercise price
receives a premium and must stand ready to buy bonds at the exercise price
pays a premium and has the right to sell the underlying bond at the agreed exercise price
pays a premium and has the right to buy the underlying bond at the agreed exercise price

54.
As interest rates increase, the writer of a bond call option stands to make:

A.
B.
C.
D.

limited gains
limited losses
unlimited losses
unlimited gains

55.
What kind of interest rate swap (of liabilities) would an FI with a positive funding gap utilise to hedge interest rate risk exposure?

A.
B.
C.
D.

swap in floating-rate payments for fixed-rate payments

swap in floating-rate receipts for fixed-rate payments
swap in fixed-rate receipts for floating-rate receipts
swap in floating-rate receipts for fixed-rate receipts

56.
A call option is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be
exchanged for cash at some later date.

True

False

57.
A forward contract is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be
exchanged for cash at some later date.

True

False

58.
A futures contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

True

False

59.
A forward contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

True

False

60.
Forwards are on-balance-sheet transactions.

True

False

61.
Some futures exchanges have deliverable bond futures, meaning that at the contract's expiry holders of bought futures positions
must take physical delivery and sellers must make delivery.

True

False

62.
The Sydney Futures Exchange only offers cash-settled contracts.

True

False

63.
For a currency that has a futures contract, basis risk is not typically a problem as $1 is the same as any other $1.

True

False

64.
Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

True

False

65.
Basis risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the
movement in the price of the asset delivered under a futures or forward contract.

True

False

66.
Firm-specific risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the
movement in the price of the asset delivered under a futures or forward contract.

True

False

67.
All call options are eventually exercised and the underlying asset must be delivered.

True

False

68.
In a put option, the purchaser of the bond option is committed to handing over the specified bond at a specified time.

True

False

69.
An interest rate swap is a succession of forward contracts on interest rates arranged by two parties that allows for the exchange of
fixed-interest payments for floating payments; as such, it allows an FI to place a long-term hedge.

True

False

70.
It is possible to create a synthetic fixed-rate position from floating-rate instruments using futures contracts. Forward contracts cannot
be used.

True

False

71.
When calculating the number of hedges required for a position, the number should always be rounded up to cover the full position.

True

False

72.
Off-market swaps are swaps that are have non-standard terms that require one party to compensate another so the swap can be
tailored to the needs of the transacting parties; compensation is usually in the form of an upfront fee or payment.

True

False

73.
Buying a call option (standing ready to buy bonds at the exercise price) is a strategy that an FI may take when bond prices rise and
interest rates are expected to fall.

True

False

74. Explain how hedging affects risk and return. Use a diagram to stress your points. In your answer differentiate between
routine hedging and hedging selectively.

75. Explain the differences between using futures and options contracts to hedge interest rate risk. Use diagrams where
possible to support your points.

Chapter 07 Testbank Key

1.
A ... is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be exchanged for
cash at some later date.

A. call option
B. put option
C. forward contract
D. swap
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

2.
A ... is a (non-standard) contract between two parties to deliver and pay for an asset in the future.

A. call option
B. put option
C. forward contract
D. swap
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

3.
A ... is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

A. call option
B. put option
C. forward contract
D. futures contract
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

4.
Which of the following statements is true?

A. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each hour to
reflect current futures market conditions.
B. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each day to
reflect current futures market conditions.
C. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each week
to reflect current futures market conditions.
D. Marking to market refers to the process by which the prices on outstanding futures contracts are adjusted each month
to reflect current futures market conditions.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

5.
... is the process by which the prices on outstanding futures contracts are adjusted each day to reflect current futures market
conditions.

A. Hedging
B. Marking to market
C. Arbitrage
D. Securitisation
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

6.
Which of the following statements is true?

A. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a
dollar hedge.
B. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a plain
hedge.
C. If a cash asset is hedged on a dollar for dollar basis with a forward or futures contract, we refer to this hedge as a
nave hedge.
D. All of the listed options are correct.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.1 Discover the role that derivative contracts play in an FI's activities

7.
In a 'plain Vanilla swap' the swap buyer agrees to make:

A. fixed-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the
use of derivatives to turn it into a fixed-rate loan
B. fixed-interest payments to the swap seller on a loan that is originally fixed, but which is then modified through the use
of derivatives to turn it into a floating-rate loan
C. floating-interest payments to the swap seller on a loan that is originally floating, but which is then modified through the
use of derivatives to turn it into a fixed loan
D. None of the listed options are correct.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Hard
Est time: 13
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

8.
Which of the following statements is true?

A.
B.
C.
D.

Using a futures or forward contract to hedge a specific asset or liability risk is called macrohedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called microhedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called asset- or liability-specific hedging.
Using a futures or forward contract to hedge a specific asset or liability risk is called nave hedging.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

9.
Which of the following statements is true?

A.
B.
C.
D.

Microhedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
Macrohedging refers to hedging the entire duration gap of an FI using futures or forward contracts.
Microhedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.
Macrohedging refers to hedging the entire balance sheet of an FI using futures or forward contracts.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

10.
Which of the following statements is true?

A.
B.
C.
D.

Routine hedging seeks to hedge all interest rate risk exposure.

Routine hedging seeks to hedge all foreign exchange rate risk exposure.
Routine hedging seeks to hedge all liquidity risk exposure.
Routine hedging seeks to hedge all capital risk exposure.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

11.
... is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the movement in
the price of the asset delivered under a futures or forward contract.

A. Macro risk
B. Micro risk
C. Basis risk
D. Duration risk
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

12.
Partially hedging the gap or individual assets and liabilities is referred to as?

A.
B.
C.
D.

hedging arbitrarily
hedging selectively
hedging partially
hedging naively

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

13.
The final settlement in which all bought and sold futures contracts in existence at the close of trading in the contract month are
settled at the cash settlement price is called a:

A.
B.
C.
D.

periodical cash settlement

mandatory cash settlement
monthly cash settlement
final cash settlement

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

14.
An undeliverable futures contract refers to a futures contract in which:

A.
B.
C.
D.

there is no physical settlement

there is no mandatory cash settlement
one of the parties is unable to deliver
money has been lost due to a party having chosen an unfavourable hedging strategy

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

15.
Which of the following is an adequate definition of conversion factor?

A. A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is
delivered to the buyer.
B. A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the buyer.
C. A factor used to calculate the invoice price on a futures contract when a bond other than the benchmark bond is
delivered to the seller.
D. A factor used to calculate the invoice price on a futures contract when the benchmark bond is delivered to the seller.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

16.
Within the futures market, to be fully hedged means:

A. Buying a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
B. Selling a sufficient number of futures contracts so that the loss of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
C. Selling a sufficient number of futures contracts so that the gain of net worth on the FI's balance sheet when interest
rates rise is just offset by the gain from the off-balance-sheet selling of futures when interest rates rise.
D. None of the listed options are correct.
AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 35
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

17.
The dollar value of the outstanding futures position depends on the:

A.
B.
C.
D.

number of contracts bought and sold and the price of each contract
cash exposure ratio
number of contracts bought and sold and the change in interest rates
contracts that should be sold per dollar of cash exposure

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

18.
Which of the following are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a prespecified price for a specified time period?

A.
B.
C.
D.

options
futures
forwards
swaps

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

19.
Which of the following statements is true?

A.
B.
C.
D.

In equity markets, delivery and cash settlement normally occur two business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur three business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur four business days after the spot agreement.
In equity markets, delivery and cash settlement normally occur five business days after the spot agreement.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

20.
Which of the following is a major difference between forwards and futures?

A. Forwards are marked to market, while futures are not.

B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked to market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

21.
An Australian bank must pay US$10 million in 90 days. It wishes to hedge the risk in the futures market. To do so, the bank should:

A.
B.
C.
D.

buy A$10 million in US dollar futures

sell A$10 million in US dollar futures, with three-month maturity
buy US$10 million in US dollar futures
sell US$10 million in US dollar futures

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

22.
Which of the following is true of the market price of a futures contract over time?

A.
B.
C.
D.

It is set at time 0.
It is fixed over the life of the contract.
It changes based on the market value of the underlying asset.
It decreases with time to expiration.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

23.
Which of the following statements is true?

A. In a spot contract the buyer and seller enter into a contract at time 0, the contract is marked to market, the seller
agrees on a price at time 0 and the bonds is delivered by the seller to the buyer 'at that time'.
B. In a spot contract the buyer and seller agree on a price at time 0 and the bonds is delivered by the seller at a future
point in time, for example, after three months.
C. In a spot contract the buyer and on a daily basis, and the buyer pays the spot price quoted at expiry.
D. None of the listed options are correct.
AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

24.
Which of the following statements is true?

A. In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the
buyer 'at that time'.
B. In a forward contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a
future point in time, for example, after three months.
C. In a forward contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily
basis, and the buyer pays the forward price quoted at expiry.
D. None of the listed options are correct.
AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

25.
Which of the following statements is true?

A. In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller to the
buyer 'at that time'.
B. In a futures contract the buyer and seller agree on a price at time 0 and the bonds are delivered by the seller at a
future point in time, for example, after three months.
C. In a futures contract the buyer and seller enter into a contract at time 0, the contract is marked to market on a daily
basis, and the buyer pays the futures price quoted at expiry.
D. None of the listed options are correct.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

26.
Which of the following statements is true?

A. A very actively traded spot contract is the spot rate agreement (SRA).
B. A very actively traded spot contract is the futures rate agreement (FRA).
C. A very actively traded forward contract is the forward rate agreement (FRA), commonly used to lock in the interest rate
on shorter term borrowings.
D.
A very actively traded spot contract is the option rate agreement (ORA), commonly used to grant the right to buy or sell an asset at a
specified price.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

27.
Which of the following is a common use of FRAs?

A.
B.
C.
D.

To lock in an interest rate on relatively shorter term borrowings.

To lock in an interest rate on medium-term borrowings.
To lock in an interest rate on relatively longer term borrowings.
To lock in an interest rate on any term of borrowings.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

28.
Which of the following statements is true?

A. In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-market process.
B. In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-market process.
C. In a futures contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-book value process.
D. In a forward contract, daily cash flows pass, via the clearing house, between the buyer and seller in response to the
mark-to-book value process.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

29.
A company is considering using futures contracts to hedge an identified interest rate exposure on its debt facilities. However, it is
concerned about the impact of basis risk. All of the following statements regarding basis risk are correct, except:

A. basis risk is the difference between prices in the physical market and the price of the relevant futures market contract.
B. the existence of basis risk removes the opportunity for a perfect borrowing hedge.
C. initial basis will be evident while the market is of the view that physical market prices will remain stable.
D. final basis will exist where a futures contract is used to hedge a risk associated with a different physical market
product.
AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

30.
An FI portfolio manager holds 10-year $1 million face value bonds. At time 0, these bonds are valued at $95 per $100 of face value
and the manager expects interest rates to rise over the next three months. What should the manager do?

A. The FI portfolio manager should leave the position untouched as changes in the interest rate have no impact on bond
prices.
B. The FI portfolio manager should leave the position untouched as an increase in interest rates will lead to higher bond
prices.
C. The FI portfolio manager should hedge the position by selling a three months forward contract with a face value of $1
million.
D. The FI portfolio manager should hedge the position by buying a three months forward contract with a face value of $1
million.
AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 35
Learning Objective: 7.6 Discover how to use options to manage interest rate risk

31.
Assume that the price paid by the buyer of a forward is $82 000 and further assume that the spot price of purchasing the hedged
underlying asset at delivery date is $85 000. What is the result for the forward seller?

A.
B.
C.
D.

The result is a $3000 profit.

The result is a $3000 loss.
The answer depends on how the forward price develops over time.
There is too little information to answer the question.

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

32.
Financial futures are used by FIs to manage:

A.
B.
C.
D.

credit risk
interest rate risk
liquidity risk
sovereign country risk

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

33.
A forward contract:

A.
B.
C.
D.
E.

has more credit risk than a futures contract

is more standardised than a futures contract
is marked to market more frequently than a futures contract
has a shorter time to delivery than a futures contract
is less risky than a futures contract.

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

34.
The benefit of a futures exchange is:

A.
B.
C.
D.

elimination of customer risk exposure

provision of clearing services
guarantee of trading volume
intervention on the trader's behalf with government regulators

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

35.
In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities. In June, the
91-day Treasury bill rate is 5.50 per cent. What is the investor's profit (loss) if the 91-day rate falls to 5.20 per cent in September?

A.
B.
C.
D.

The investor loses $30 000 because of the 30 basis point decline in interest rates.
The investor gains $30 000 because of the 30 basis point decline in interest rates.
The investor gains $7583 because of the 30 basis point decline in interest rates.
The investor loses $7583 because of the 30 basis point decline in interest rates.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 35
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

36.
In June, an investor finds out that in September she will receive $10 million to invest in three-month maturity securities. In June, the
91-day Treasury bill rate is 5.50 per cent. If the investor uses 10 T-bill futures contracts to hedge the interest rate risk, should she
take a long or a short hedge? What are the returns on the futures hedge if there is no basis risk?

A.
B.
C.
D.

She earns $30 000 on the short futures hedge.

She earns $30 000 on the long futures hedge.
She earns $7500 on the short futures hedge.
She earns $7500 on the long futures hedge.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 35
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

37.
Which of the following statements is true?

A. The advantage of using forwards for creating a synthetic fixed rate position is that there are no cash flows until the
contract matures.
B. The advantage of using futures for creating a synthetic fixed rate position is that futures contracts are standardised.
C. The advantage of using forwards for creating a synthetic fixed rate position is that futures contracts are standardised.
D.
The advantage of using futures for creating a synthetic fixed rate position is that there are no cash flows until the contract matures.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

38.
Which of the following statements is true?

A. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called value risk.
B. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called basis risk.
C. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called gap risk.
D. The mismatches between changes in the price of the exposure and the value of the instrument used to hedge the
position is called fundamental risk.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

39.
Which of the following statements is true?

A.
B.
C.
D.

Micro- and macrohedging always lead to the same hedging strategies and results.
Micro- and macrohedging can lead to the same hedging strategies but will lead to different results.
Micro- and macrohedging will lead to different hedging strategies but will also lead to the same results.
Micro- and macrohedging can lead to different hedging strategies and results.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

40.
Which of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract?

A. Forward contracts are classified as exotic derivatives.

B. Margin requirements on futures.
C. More flexibility as the buyer can decide whether or not to exercise the contract at maturity.
D. None of the listed options are correct, as the default risk of a futures contract is generally considered to be higher than
that of a forward contract.
AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

41.
Which of the following statements is true?

A. Over-hedging will lead to a significant reduction in risk, but also in returns.

B. In terms of risk and return, there is a linear relationship between an unhedged, a selectively hedged, a fully hedged
and an over-hedged position.
C. It is not possible to over-hedge a position.
D. Over-hedging will lead to a significant reduction in risk, but also in returns, in terms of risk and return, there is a linear
relationship between an unhedged, a selectively hedged, a fully hedged and an over-hedged position and it is not possible
to over-hedge a position.
AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

42.
What is a swap?

A. An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a
specified interval.
B. An agreement between a buyer and a seller at time 0 to exchange a non-standardised asset for cash at some future
date.
C. A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price
within a specified period of time.
D. Trading in securities prior to their actual issue.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

43.
Which of the following best describes a derivative contract?

A. Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B. Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C. Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified
date in the future.
D. Trading in securities prior to their actual issue.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.1 Discover the role that derivative contracts play in an FI's activities

44.
Which of the following statements is true?

A.
B.
C.
D.

In Australian interest rate futures there is no physical settlement of either 10-year or three-year bond futures.
In Australian interest rate futures there is no physical settlement of either 10-year or five-year bond futures.
In Australian interest rate futures there is no physical settlement of either five-year or three-year bond futures.
In Australian interest rate futures there is always physical settlement.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

45.
In a put option on a bond, the:

A.
B.
C.
D.

seller of the put option is committed to receive the underlying bond at a specified time
buyer of the put option is committed to handing over the specified bond at a specified time to the seller of the option
buyer of the option is committed to receive the underlying bond at a specified time
seller of the bond is committed to handing over the specified bond at a specified time

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

46.
A major difference between a forward and a futures contract:

A.
B.
C.
D.

is the forward has less credit risk than a futures contract

is the forward contract is tailor-made to fit the needs of the buyer
is the forward contract is marked to market more frequently than a futures contract
is the forward contract rarely has final delivery of the asset

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

47.
A futures contract:

A.
B.
C.
D.

is tailor made to fit the needs of the buyer and the seller
has more price risk than a forward contract
is marked to market more frequently than a forward contract
has a shorter time to delivery than a forward contract

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

48.
An agreement between a buyer and a seller at time 0 where the seller of an asset agrees to deliver an asset immediately and the
buyer agrees to pay for the asset immediately is the characteristic of a:

A.
B.
C.
D.

spot contract
forward contract
futures contract
put options contract

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

49.
What is a difference between a forward contract and a future contract?

A. The settlement price of a forward contract is fixed over the life of the contract but in a futures contract is marked to
market daily.
B. Forward contracts are normally arranged through an organised exchange, while most futures contracts are OTC
contracts.
C. Both are essentially the same, except for the fact that the terms of a forward contract is set by the exchange, subject to
the approval of the SFE.
D. Delivery of the underlying asset almost always occurs on a futures contract but almost never occurs on a forward
contract.
AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

50.
Which of the following is an example of microhedging asset-side portfolio risk?

A. When an FI, attempting to lock in cost of funds to protect itself against a rise in short-term interest rates, takes a short
position in futures contracts on CDs.
B. FI manager trying to pick a futures contract whose underlying deliverable asset is not matched to the asset position
being hedged.
C. When an FI hedges a cash asset on a direct dollar for dollar basis with a forward or futures contract.
D. When an FI manager wants to insulate the value of the institution's bond portfolio fully against a rise in interest rates.
AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

51.
An FI has reduced its interest rate risk exposure to the lowest possible level by selling sufficient futures to offset the risk exposure of
its whole balance sheet or cash positions in each asset and liability. The FI is involved in:

A.
B.
C.
D.

microhedging
selective hedging
routine hedging
over-hedging

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

52.
The buyer of a bond call option:

A.
B.
C.
D.

receives a premium in return for standing ready to sell the bond at the exercise price
receives a premium in return for standing ready to buy bonds at the exercise price
pays a premium and has the right to sell the underlying bond at the agreed exercise price
pays a premium and has the right to buy the underlying bond at the agreed exercise price

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

53.
The writer of a bond call option:

A.
B.
C.
D.

receives a premium and must stand ready to sell the bond at the exercise price
receives a premium and must stand ready to buy bonds at the exercise price
pays a premium and has the right to sell the underlying bond at the agreed exercise price
pays a premium and has the right to buy the underlying bond at the agreed exercise price

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 13
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

54.
As interest rates increase, the writer of a bond call option stands to make:

A.
B.
C.
D.

limited gains
limited losses
unlimited losses
unlimited gains

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

55.
What kind of interest rate swap (of liabilities) would an FI with a positive funding gap utilise to hedge interest rate risk exposure?

A.
B.
C.
D.

swap in floating-rate payments for fixed-rate payments

swap in floating-rate receipts for fixed-rate payments
swap in fixed-rate receipts for floating-rate receipts
swap in floating-rate receipts for fixed-rate receipts

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 13
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

56.
A call option is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be
exchanged for cash at some later date.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

57.
A forward contract is an agreement between a buyer and seller at time 0, when there is a contractual agreement that an asset will be
exchanged for cash at some later date.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

58.
A futures contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

59.
A forward contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 13
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

60.
Forwards are on-balance-sheet transactions.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 7.1 Discover the role that derivative contracts play in an FI's activities

61.
Some futures exchanges have deliverable bond futures, meaning that at the contract's expiry holders of bought futures positions
must take physical delivery and sellers must make delivery.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

62.
The Sydney Futures Exchange only offers cash-settled contracts.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures

63.
For a currency that has a futures contract, basis risk is not typically a problem as $1 is the same as any other $1.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

64.
Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

65.
Basis risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the
movement in the price of the asset delivered under a futures or forward contract.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

66.
Firm-specific risk is a residual risk that arises because the movement in a spot (cash) asset's price is not perfectly correlated with the
movement in the price of the asset delivered under a futures or forward contract.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 13
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging

67.
All call options are eventually exercised and the underlying asset must be delivered.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

68.
In a put option, the purchaser of the bond option is committed to handing over the specified bond at a specified time.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

69.
An interest rate swap is a succession of forward contracts on interest rates arranged by two parties that allows for the exchange of
fixed-interest payments for floating payments; as such, it allows an FI to place a long-term hedge.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

70.
It is possible to create a synthetic fixed-rate position from floating-rate instruments using futures contracts. Forward contracts cannot
be used.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

71.
When calculating the number of hedges required for a position, the number should always be rounded up to cover the full position.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

72.
Off-market swaps are swaps that are have non-standard terms that require one party to compensate another so the swap can be
tailored to the needs of the transacting parties; compensation is usually in the form of an upfront fee or payment.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management

73.
Buying a call option (standing ready to buy bonds at the exercise price) is a strategy that an FI may take when bond prices rise and
interest rates are expected to fall.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

74. Explain how hedging affects risk and return. Use a diagram to stress your points. In your answer differentiate between
routine hedging and hedging selectively.

Routine hedging occurs when an FI reduces its interest rate or other risk exposure to its lowest possible level by trading sufficient
futures to offset the interest rate risk exposure of its whole balance sheet or cash positions in each asset and liability. For example, this
might be achieved by macrohedging the total balance sheets duration gap.
However, since reducing risk also reduces return, not all FI managers seek to do this. Indeed a manager would only follow this strategy
if the direction and size of interest rate changes are extremely unpredictable, to the extent that the manager is willing to forgo return to
hedge this risk. The following diagram shows the trade-off between return and risk and the minimum-risk of a fully hedged portfolio.

Rather than a fully hedged position, many FIs choose to bear some interest rate risk as well as credit and FX risks because of their
comparative advantage as FIs. One possibility is that an FI may choose to hedge selectively its portfolio. For example, an FI manager
may generate expectations regarding future interest rates before deciding on a futures position. As a result, the manager may
selectively hedge only a proportion of the Fls balance sheet position. Alternatively, the manager may decide to remain unhedged or
even to over-hedge by selling more futures than required by the cash position.
Thus, the fully hedged positionand the minimum risk portfoliobecomes one of several choices depending, in part, on managerial
interest rate expectations, managerial objectives and the nature of the returnrisk trade-off from hedging.

AACSB: Communication
Bloom's: Application
Difficulty: Hard
Est time: 510
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts

75. Explain the differences between using futures and options contracts to hedge interest rate risk. Use diagrams where
possible to support your points.

To understand the differences between using futures and options contracts to hedge interest rate risk, compare the profit gains for
buying futures contracts with those for buying put option contracts. This can be seen in the following diagrams:

Buying a futures contract to hedge the interest rate risk on a bond

Buying a put option to hedge the interest rate risk on a bond

Using futures contracts to hedge reduces volatility in profit gains and losses (i.e. on the upside and downside of interest rate
movements). That is, if the FI loses value on the bond resulting from an interest rate increase (to the left of point X), a gain on the
futures contract offsets the loss. If the FI gains value on the bond due to an interest rate fall (to the right of point X), a loss on the futures
contract will offset the gain.
By comparison, the hedge using the put option contract completely offsets losses (apart from the premium) but only partly offsets
gains. This is shown in the following diagram:
Net payoff of buying a bond put and investing in a bond

Here we can see, if interest rates fall, then the FI gains value on the bond (to the right of X), but the gain is offset only to the extent of
the put option premium (because it will not exercise the option). Thus, the put option hedge protects the FI against value losses when
interest rates move against the on-balance-sheet securities. However, unlike futures hedging, it does not reduce all the value gained
when interest rates move in favour of on-balance-sheet securities.

AACSB: Communication
Bloom's: Application
Difficulty: Hard
Est time: 510
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options

Chapter 07 Testbank Summary

Category
# of Questions
AACSB: Analytic
73
AACSB: Communication
2
Bloom's: Application
43
Bloom's: Knowledge
32
Difficulty: Easy
17
Difficulty: Hard
12
Difficulty: Medium
46
Est time: 13
51
Est time: 35
4
Est time: 510
2
Est time: <1
18
Learning Objective: 7.1 Discover the role that derivative contracts play in an FI's activities
3
Learning Objective: 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures
52
Learning Objective: 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts
25
Learning Objective: 7.4 Understand how basis risk can reduce the effectiveness of hedging
6
Learning Objective: 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put opti
9
ons
Learning Objective: 7.6 Discover how to use options to manage interest rate risk
1
Learning Objective: 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk mana
6
gement