Explain the accounting of hedging currency translation of a firm’s foreign subsidiary.
> Standardization of a derivatives contract on an exchange applies to all of the following except? a. Expiration b. Size of contract c. Type of commodity d. Price of derivative
> What are the major functions of derivative markets in an economy?
> On September 26 of a particular year, the March Treasury bond futures contract settlement price as 94–22. Compare the following two bonds and determine which is the cheaper bond to deliver. Assume that delivery will be made on March 1. Use 5.3 percent as
> Why is delivery important if so few futures contracts end in delivery?
> How is the volatility of the underlying stock reflected in the binomial model?
> Interpret the following statements about value at risk so that they would be easily understood by a nontechnical corporate executive: a. VAR of $1.5 million, one week, probability 0.01. b. VARof$3.75million, one year, probability 0.05
> Identify three presuppositions for well-functioning financial markets.
> The binomial model can be used to price unusual features of options. Consider the following scenario: A stock priced at $75 can go up by 20 percent or down by 10 percent per period for three periods. The risk-free rate is 8 percent. A European call optio
> Why is the bid–ask spread a transaction cost?
> How are swaps like combinations of forward contracts?
> Identify two ways to express interest rate parity based on how interest rates are quoted. Explain why, in practice, they contain the same information.
> What is the difference between bilateral clearing and multilateral clearing?
> Explain the advantages and disadvantages of notional amount compared to market value in measuring OTC derivatives market activity.
> Explain the advantages and disadvantages to a covered call writer of closing out the position prior to expiration.
> What role does the Basel Committee on Bank Supervision play in derivatives regulation? Why is it not perfectly effective?
> What role do professional codes of ethics play in governing how people manage their financial careers?
> What is the purpose of the ISDA Master Agreement? How does it provide for a means of reducing credit risk?
> If an individual anticipates the price of a stock falling, how would he go about shorting the stock to capture a profit? How does his short position create a liability?
> Assume that you are faced with an opportunity made up of three equally likely outcomes. If the first outcome occurs, you receive $10. If the second outcome occurs, you receive no money. If the third outcome occurs, you must pay out $1. Given that you can
> What contract would two parties utilize if they agreed to exchange cash flows? How might this transaction proceed?
> All derivatives are based on the random performance of something. Identify and discuss this “something.
> Compare and contrast options and forward contracts.
> Suppose you buy a stock index futures contract at the opening price of 452.25 on July 1. The multiplier on the contract is 500, so the price is $500 452 25 $226,125 You hold the position until selling it on July 16 at the opening price of 435.50. The ini
> An option dealer needs to finance the purchase of a security and holds an inventory of U.S. Treasury bills. Explain how the dealer can use the repo market for financing the security purchase?
> A short stock can be protected by selling a put. Determine the profit equations for this position and identify the breakeven stock price at expiration and maximum and minimum profits.
> Contrast dollar return and percentage return. Be sure to identify which return is more useful when comparing investments.
> Assume that you have an opportunity to visit a civilization in outer space. Its society is at roughly the same stage of development as the U.S. society is now. Its economic system is virtually identical to that of the United States, but derivative tradin
> Using an example, compare and contrast physical delivery and cash settlement.
> Why is speculation controversial? How does it differ from gambling?
> What are daily price limits and how are they used by futures exchanges?
> Give an example of an in-the-money call and put and an out-of-the-money call and put.
> What is storage? Why is it risky? What role does it play in the economy?
> Suppose you are shopping for a new automobile. You find the same car at two dealers but at different prices. Is the law of one price being violated? Why or why not?
> Define arbitrage and the law of one price. What role do they play in the U.S. market system? What do we call the “one price” of an asset?
> Explain the differences among the three means of terminating a futures contract: an offsetting trade, cash settlement, and delivery?
> A short position in stock can be protected by holding a call option. Determine the profit equations for this position and identify the breakeven stock price at expiration and maximum and minimum profits.
> Repeat problem 10, but close the position on August 1. Use the spreadsheet to find the profits for the possible stock prices on August 1. Generate a graph and use it to identify the approximate breakeven stock price.
> What is an efficient market? Why do efficient markets benefit society?
> Consider a call option on an asset with an exercise price of $100, a put option on that same asset with an exercise price of $100, and a forward contract on the asset with an exercise price of $100, all expiring at the same time. Assume that at the expir
> What responsibilities does senior management assume in a risk management system?
> What is the purpose of risk management industry standards?
> Summarize in one sentence how each of the following organizations failed to practice risk management: a. Metallgesellschaft b. Orange County c. Barings d. Procter & Gamble
> Describe the primary differences between accounting for fair value hedges and accounting for cash flow hedges.
> Explain how an organization determines whether a hedge is sufficiently effective to justify hedge accounting.
> Why is hedge accounting used, and how can it be misused?
> Explain how cash flow hedge accounting is applied in principle. Specifically, identify how this accounting treatment is different from the typical way cash flow transactions accounting is handled.
> Explain why the traditional auditing function cannot serve as the risk management function.
> We briefly mentioned the synthetic call, which consists of stock and an equal number of puts. Assume that the combined value of the puts and stock exceeds the value of the actual call by less than the present value of the exercise price. Show how an arbi
> Explain the basic differences between open outcry and electronic trading systems.
> ACB, Inc., engages in a forward transaction and is applying fair value hedge accounting. ACB holds the underlying instrument and hedges it by selling this forward contract. During the hedge period, the underlying instrument increases in value by $250,000
> Define and explain what is meant by independent risk monitoring. How can senior management improve independent risk monitoring?
> Explain the advantages for senior management having detailed written policies for financial risk management.
> Suppose that a firm plan to purchase an asset at a future date. The forward price of the asset is $200,000. It hedges that purchase by buying a forward contract at a price of $205,000. During the hedging period, the forward contract incurs a paper loss o
> Suppose that a firm engages in a derivative transaction that qualifies for fair value hedging. The firm holds a security and hedges it by selling a derivative. During the course of the hedge, the security increases in value by $20,000, whereas the deriva
> Identify and discuss five problems with regard to the application of FAS 133.
> One responsibility of senior management is to identify acceptable risk management strategies. Identify three categories of risk, focusing on broad classifications and not on specific types of risks.
> Briefly explain how speculative derivatives transactions are treated from an accounting perspective.
> You have inherited some stock from a wealthy relative. The stock had poor performance recently, and analysts believe it has little growth potential. You would like to write calls against the stock; however, the will stipulates that you must agree not to
> Distinguish between the front office and the back office of a derivatives dealer. Explain why it is important to keep the front and back offices separate.
> What is the difference between an initial margin and a maintenance margin? What is the variation margin?
> Compare and contrast view-driven risk management with needs-driven risk management.
> Identify and discuss benefits for managing financial risks.
> How does the legal system impose risk on a derivatives dealer?
> Explain how closeout netting reduces the credit risk for two firms engaged in several derivatives contracts?
> Comment on the current credit risk assumed for each of the following positions. Treat them separately, that is, not combined with any other instruments. a. You are short an out-of-the-money interest rate call option. b. You entered into a pay-fixed, re
> Critique each of the three methods of calculating value at risk, giving one advantage and one disadvantage of each.
> A company has assets with a market value of $100. It has one outstanding bond issue, a zero coupon bond maturing in two years with a face value of $75. The risk-free rate is 5 percent. The volatility of the asset is 0.30. Determine the market value of th
> Suppose you enter into a bet with someone in which you pay $5 up front and are allowed to throw a pair of dice. You receive a payoff equal to the total in dollars of the numbers on the two dice. In other words, if you roll a 1 and a 2, your payoff is $3
> Suppose an investor is considering buying one of two call options on a particular stock with the same maturity. The only difference between the two call options is the strike prices. The rate of return on a call option is its profit divided by the invest
> Company CPN and dealer Swap Fin are engaged in three transactions with each other. From Swap Fin’s perspective, the market values are as follows: Explain the consequences to SwapFin if CPN defaults with and without closeout netting. In
> Suppose you own 50,000 shares of stock valued at $35.50 per share. You are interested in protecting it with a put that would have a delta of 0.62. Assume however, that the put is not available or is unfairly priced. Illustrate how to construct a dynamic
> How can one make a profit from a transaction in light of the bid–ask spread, assuming the spread remains constant?
> Identify and explain four forms of netting.
> The following table lists three financial instruments and their deltas, gammas, and vegas for each $1 million notional amount under the assumption of a long position. (Long in a swap or FRA means to pay fixed and receive floating.) Assume that you hold a
> Calculate the VAR for the following situations: a. Use the analytical method and determine the VAR at a probability of 0.05 for a portfolio in which the standard deviation of annual returns is $2.5 million. Assume an expected return of $0.0. b. Use the
> Consider a portfolio consisting of $10 million invested in the S&P 500 and $7.5 million invested in U.S. Treasury bonds. The S&P 500has an expected return of 14 percent and a standard deviation of 16 percent. The Treasury bonds have an expected return of
> Suppose the periodic payments made by a CDS buyer to a CDS seller are worth $1 per $100 notional value of debt per quarter. Explain how this figure is related to the value of the debt and the value of an otherwise equivalent bond that is default free.
> Suppose your firm is a derivatives dealer that has recently created a new product. In addition to market and credit risk, what additional risks does it face that are associated more with new products?
> Identify the five types of credit derivatives and briefly describe how each works.
> Another consideration in evaluating option strategies is the effect of transaction costs. Suppose that purchases and sales of an option incur a brokerage commission of 1 percent of the option’s value. Purchases and sales of a share of stock incur a broke
> Explain how the stockholders of a company hold an implicit put option written by the creditors.
> Consider a firm that has assets that generate cash but which cannot be easily valued on a regular basis. What are the difficulties faced by this firm when using VAR, and what alternatives would it have?
> Compare and contrast total return swaps, credit default swaps, and interest rate swaps.
> Referring to problem 15, suppose transaction costs amounted to 0.5 percent of the value of the stock index. Explain how these costs would affect the profitability and the incidence of index arbitrage. Then calculate the range of possible futures prices w
> Identify and explain the primary methods of managing credit risk for derivatives dealers.
> Determine the prices of lookback and modified lookback calls and puts. For the modified lookbacks, use an exercise price of 95.
> Determine the price of an average price Asian call option. Use an exercise price of 95. Count the current price in determining the average. Comment on whether you would expect a standard European call to have a lower or higher price.
> Use the information in problem 9 to set up a dynamic hedge using stock index futures Assume a multiplier of 500. The futures price is 496.29. The volatility is 17.5 percent. The continuously compounded risk-free rate is 3.6 percent, and the call delta is
> On July 5, a market index is at 492.54. You hold a portfolio that duplicates the index and is worth 20,500 times the index. You want to insure the portfolio at a particular value over the period until September 20. You can buy risk-free debt maturing on
> In modern financial derivatives markets, there are many exotic options. Briefly explain compound options, multi-asset options, shout options, and forward start options.
> Suppose the call price is $14.20 and the put price is $9.30 for stock options, where the exercise price is $100, the risk-free interest rate is 5 percent (continuously compounded), and the time to expiration is one year. Explain how you would create a sy
> Explain how weather derivatives could be used by an electric utility to manage the risk associated with power consumption as affected by the weather.
> Demonstrate that the payoffs of a chooser option with an exercise price of X and a time to expiration of T that permits the user to designate it as a call or a put at t can be replicated with two transactions. Specifically, by (1) buying a call with an e
> A convertible bond is a bond that permits the holder to turn in the bond and convert it into a certain number of shares of stock. Conversion would, thus, occur only when the stock does well. As a result of the option to convert the bond to stock, the cou
> Suppose you are asked to assist in the design of an equity-linked security. The instrument is a five-year zero coupon bond with a guaranteed return of 1 percent, compounded annually. At the end of five years, the bond will pay an additional return based
> In this chapter, there are two equations presented for the implied repo rate related to the following bond futures contracts. Explain these equations and discuss the differences between them (1/T) ((CF)[fo(t) + AlT + Clo,r -1 and Bo + Al, CF(t)]fo(t)
> Contrast lookback options and barrier options and explain the difference between in- and out options.
> Derive the terminal stock price of a portfolio insurance strategy with put options such that the upside capture exactly equals 100 percent.
> Suppose an investor owns 1,000 shares of Pear, Inc., stock that is trading at $100 per share. Design a portfolio insurance strategy assuming a strike price of $100, time to maturity of one year, and a put price of $9.35 per share. Compute the number of p
> An investment manager expects a stock to be quite volatile and is considering the purchase of either a straddle or a chooser option. The stock is priced at 44, the exercise price is 40, the continuously compounded risk-free rate is 5.2 percent, and the v
