Chapter 24 Hedging with Derivative Contracts

Chapter 24 Hedging with Derivative Contracts I. Multiple Choice 1. Which of the following is not a factor that influences the price of a call option at a given point in time t? a. b. c. d. the price of the underlying asset at time t the exercise price of the option the date that the option was first created the interest rate on government bonds (risk free rate) Answer: c Type: K 2. A call option price will increase, all else equal, when: a. b. c. d. the price of the underlying asset decreases the volatility of the return on the underlying asset increases the interest rate on government bonds decreases time to maturity decreases Answer: b Type: A 3. Call option A has an exercise price of $20. Call option B has an exercise price of $15. If all other characteristics of these options are identical and they are on the same underlying asset, which option will have a higher price? a. b. c. d. Call option A will have a higher price. Call option B will have a higher price. Call option A and Call option B will have the same price. It is impossible for two options on the same underlying asset to have different exercise prices. Answer: b Type: A 4. Option X and Option Y have the same underlying security and the same exercise price. If Option X has 3 months to maturity and Option Y has 6 months to maturity, which option will have a higher price? a. b. Option X will have a higher price Option Y will have a higher price 198 c. d. Since Options X and Y are on the same underlying security, they will have the same price. Cannot be determined form the information given Answer: b Type: A 5. Which of the following statements is true about a futures contract? a. The payoff is equal to the difference between the price of the underlying asset and the futures price. The payoff is the same as that of a call option. Futures contracts always require delivery of the underlying asset to complete the contract. The futures price is paid by the buyer at the outset of the contract. b. c. d. Answer: a Type: K 6. The current spot price of oil is $12 per barrel, the interest rate is 8%, and the cost of storing and insuring oil for one year is 1% of the value of the oil. What would be the no arbitrage futures price today on a contract that expires one year from now? a. b. c. d. $12 $12.96 $13.09 $13.20 Answer: c Type: A 7. Which of the following is not a true statement about the differences between overthe-counter (OTC) derivatives and exchange traded derivatives? a. The exchange markets have a clearinghouse that acts as an intermediary in every transaction whereas the OTC contracts are between buyer and seller directly. When trading OTC contracts, default risk of the counterparty is an important consideration. OTC contracts are each individually negotiated whereas exchange traded contracts are standardized. OTC contracts are more liquid than exchange traded contracts. b. c. d. Answer: d Type: A 199 8. The type(s) of risk that is (are) very frequently hedged with derivatives are: a. b. c. d. foreign exchange risk interest rate risk commodity price risk all of the above Answer: d Type: K 9. Factors that have contributed to the use of interest rate derivatives to hedge against changes in value due to interest rate changes include: a. b. c. low interest rates in the 1990s volatility of interest rates in the 1970s and 1980s the Federal Reserve policy of trying to stabilize interest rates directly instead of targeting monetary aggregates all of the above d. Answer: b Type: K 10. Which of the following is not a determinant of forward or futures prices? a. b. c. d. the current price of the underlying asset the time to expiration the premium charged by the broker the risk free rate of interest Answer: c Type: K 11. Basis risk exists when the hedging instrument a. b. c. d. is likely to increase in value is likely to decrease in value differs in value from the item (or variable) being hedged has a high level of volatility Answer: c Type: K 12. The notional principle for swap contracts is a. b. an accurate measure of the amount of money at risk usually double the amount of money at risk 200 c. d. usually an inaccurate measure of the amount of money at risk the expected value of the payout of the contract Answer: c Type: K 13. When compared to derivative contracts, insurance contracts a. b. c. d. have greater basis risk are used to hedge losses that are more specific to a firm are more liquid tend to have lower transactions (or contracting) costs Answer: b Type: K 14. Miker wants to protect his company from the increased costs it would face if the price of corn exceeds $5 per bushel. Which of the following instruments will generate value if the price per bushel of corn should exceed $5? a. b. c. d. call option put option either a call option or a put option because both will suit his needs swap option Answer: a Type: A 15. Which of the following is not true about call options contracts? a. b. c. d. The potential payoff of a call options is asymmetrical. The underlying asset is a market variable or some other aggregate economic variable. Call option contracts are nonstandard. Call option contract can be settled without physical delivery. Answer: c Type: K II. Fill-Ins 1. A contract whose payoff or value is derived from the value of an underlying asset is known as a derivative contract. 201 2. A derivative contract in which the buyer of the contract receives a positive payoff when the value of the underlying asset is above the exercise price is called a call option . 3. A derivative contract in which the buyer of the contract receives a positive payoff when the value of the underlying asset is below the exercise price is called a put option . 4. The basis for a hedge is the difference between the value of what’s being hedged and the value of the hedging instrument . 5. An option that can be exercised at any time up to the expiration date is called a(n) American option. 6. A measure commonly used to denote the value of outstanding swap contracts is called the notional principal . 7. Synergy exists when the combination of the parts has greater value than the sum of the individual values. 8. By purchasing a put option on an underlying asset which is positively correlated with a firm’s revenue (and thus positively correlated with profits), a firm can hedge against losses due to lower than expected revenue. III. Problems and Short Answer Questions 1. Explain how an insurance contract is similar to an option contract. Answer: Both types of contracts can be used to generate cash when events occur that otherwise would have caused a loss in firm value. Firms must pay a premium for either type of contract. In both types of contracts, the firm will not make a claim or exercise the contract rights if the negative event does not occur. Type: K 2. Anacott Steel uses oil in its production process and is therefore exposed to the risk of changing oil prices. If it uses derivatives to hedge this risk, what are the types of basis risk may it be exposed to? Answer: There may be differences between the factors that affect the oil costs for Anacott and the factors that affect the value of the derivative contract for Anacott These differences create basis risk and could include;  The derivative contract may be based on a different grade of oil than the one that Anacott needs for production. 202  The maturity date of the contract may not correspond to Anacott’s purchasing requirements (e.g. if they need to buy oil every day.  The delivery locations may differ. Type: A 3. Why do insurance contracts expose the firm to less basis risk than derivative contracts? What are some of the additional costs of insurance contracts that may outweigh the reduced basis risk? Answer: Since derivative contracts are standardized and are based on market prices rather than firm specific factors, it is impossible for a gain on a derivative contract to exactly match the loss that the firm experiences. In contrast, insurance contracts are based on firm-specific outcomes and can therefore be designed to perfectly hedge the firm’s losses. Insurance contracts may be more expensive because insurers must price policies to account for moral hazard, adverse selection, and higher capital costs. Type: K 4. Draw an exposure diagram to illustrate a firm’s exposure to interest rate risk if the firm needs to borrow $1 million one year from today. Assume the loan will be a one year loan with all interest paid at the end of the year. Graph the relation between the firm’s interest costs and interest rates. Also graph the relation between the firm’s profit and interest rates assuming that higher interest costs cannot be passed on to consumers. Answer: Exposure diagram Profit Effects due to Interest Rates Interest Costs Profit Interest Rates Interest Rates Type: A 203 5. ZT company self-insures its workers’ compensation exposure. ZT is confident it can reliable predict the expected number of worker injuries (874) and the expected severity of each injury in today’s prices ($8,000). Since ZT is worried about health care inflation it has formed a contract with Index R’ Us whereby Index R’ Us will pay ZT, at year end, an amount equal to the magnitude of inflation greater than 3% for each of the expected number of worker injuries. The contract is based on an agreed to health care inflation index and ZT pays Index R’ Us a $120,000 premium. a. Construct a table detailing the payoff of this contract for health care inflation levels of 1% through 6%. b. Comment on the basis risk of this contract Answer: (a) Health Care Inflation 1% 2% 3% 4% 5% 6% Average Severity $8,080 $8,160 $8,240 $8,320 $8,400 $8,480 Total cost of expected number of injuries $7,061,920 $7,131,840 $7,201,760 $7,271,680 $7,341,600 $7,411,520 Payoff to ZT from hedge contract.* -$120,000 -$120,000 -$120,000 -$50,080 $19,840 $209,760 *Note: ZT is paying for inflation costs up to 3%. These dollars are outside the contract payoff. (b) Two types of basis risk could arise from this contract, (1) the inflation of ZT’s health care costs might deviate from the agreed upon index and (2) since the contact payoff at the end of the year the timing of the payments is a source of risk. Type: A 204