20.1 Five-Step Corporate Risk Management Process
1) The major risks assumed by firms include
A) demand risk.
B) foreign-exchange risk.
C) operational risk.
D) all of the above.
2) Aspects of demand risk controllable by the firm include
A) product quality.
B) interest rates.
C) entry of external competitors.
D) status of the regional and national economy.
3) An example of commodity risk would be
A) volatile exchange rates with countries from which
commodities are imported.
B) the price of copper for electrical contractors.
C) volatile exchange rates with countries to which
commodities are exported.
D) raw materials that do not meet quality specifications.
4) Assume that government and insurance providers pressure
physicians to prescribe generic drugs whenever possible. For the producers of
branded drugs, this change represents
A) insurable risk.
B) operational risk.
C) demand risk.
D) hedgeable risk.
5) Eliminating all possible risk will ultimately
A) guarantee the highest possible cash flow over the long
run.
B) cancel out all profits with cost of hedging.
C) result in lower expected cash flow but the highest cash
flow for the worst case scenario.
D) guarantee that the firm will not experience losses.
6) Which of the following are part of the five step
corporate risk management process?
A) Identify and understand the firm's major risks
B) Decide how much risk to assume
C) Monitor and manage the risks the firm assumes
D) All of the above
7) Firms that wish to minimize risk will attempt to
A) minimize the standard deviation of expected cash flows.
B) maximize the standard deviation of expected cash flows.
C) maximize expected cash flows.
D) balance expected cash flows with the standard deviation
of expected cash flows.
8) The optimal corporate risk management strategy is to
A) avoid or transfer every possible risk.
B) do nothing to transfer risk.
C) transfer about half the risk.
D) there is no strategy that is optimal for all firms.
9) Which of the following scenarios carries the least risk
of NOT being able to meet required payments (capital expenditure, dividend,
interest and principal requirements) totaling $96 million?
A) Expected cash flow, $116 million, standard deviation $5
million
B) Expected cash flow, $107 million, standard deviation
$5.5 million
C) Expected cash flow, $112 million, standard deviation $8
million
D) Expected cash flow, $134 million, standard deviation $38
million
10) Which of the following scenarios carries the greatest
risk of NOT being able to meet required payments (capital expenditure,
dividend, interest and principal requirements) totaling $96 million?
A) Expected cash flow, $116 million, standard deviation $5
million
B) Expected cash flow, $107 million, standard deviation
$5.5 million
C) Expected cash flow, $112 million, standard deviation $8
million
D) Expected cash flow, $134 million, standard deviation $38
million
11) Some risks cannot be transferred to other parties.
Answer: TRUE
12) Well managed firms will always seek to transfer as much
risk as possible.
Answer: FALSE
13) A major factor impacting the demand for residential
real estate is the availability of credit.
Answer: TRUE
14) Foreign-exchange risk can be important even for firms
that have only U.S. operations.
Answer: TRUE
15) A manufacturer of breakfast cereals should always be
fully hedged against both rising and falling grain prices.
Answer: FALSE
16) Political risk is only a factor when the firm is
considering foreign direct investments.
Answer: FALSE
17) In 2010, a deep water oil drilling rig owned by British
Petroleum exploded in the Gulf of Mexico resulting in the deaths of several
crew members, one of the worst ecological disasters in history, and major
financial damage to the company. How could the five step corporate risk
management process have avoided or mitigated this disaster.
Answer:
Step 1, BP
clearly did not adequately identify or understand the risks of deep water
drilling, especially the environmental risks.
Step 2, BP could have, and did,
purchase insurance which helped with the financial impact. Environmental risk,
however, is not transferable.
Step 3, BP may have assumed too much risk in this
case, however, the company did not suffer a fatal financial blow, in part
because of insurance coverage.
Step 4, BP most likely did not incorporate an adequate
assessment of risk into all of its decision making processes including the
choice of subcontractors.
Step 5, adequate monitoring and managing of the risk
factors of this project might have led to shutting down the well before the
explosion and avoided the disaster completely.
18) What is the general rule that firms should follow when
deciding how much risk to assume?
Answer:
Unfortunately, there is no such rule. Excessive aversion to risk will
cause the firm to accept only projects with low rates of return. Other means of
avoiding or transferring risk such as purchasing insurance or hedging in the
futures or derivatives market have costs that reduce or even eliminate positive
cash flows.
In the end, the firm must try to decide how much risk its shareholders
want it to accept in the pursuit of positive cash flows. At the limit, the firm
should probably try to avoid the potential for bankruptcy, while keeping in
mind that shareholders could have bought Treasury Bills but chose to buy the
company's stock.
19) What are some of the means by which firms can transfer
risk to other parties? Should firms always transfer risks when it is possible
to do so?
Answer: Firms can
purchase insurance policies which transfer certain risks to the insuring party.
Companies can and often do purchase policies to cover lawsuits brought by
employees or customers, worksite accidents, fire or storm damage, and the like.
Businesses like ski resorts can even purchase weather insurance. Firms cans use
derivatives markets (futures and options contracts) to protect themselves
against sudden spikes or declines in commodity prices or financial assets, as
well adverse moves in currency exchange rates.
Transferring risk is costly, so
it always reduces cash flows. The decision to keep or transfer risk must result
from a cost/benefit analysis and an attempt to discern the preferences of their
shareholders.
20.2 Managing Risk with Insurance Contracts
1) Which of the following types of risk cannot typically be
transferred to an insurance company?
A) Losses due to property damage from storms
B) Losses due to on-the job injuries suffered by employees
C) Losses due to rising raw materials costs that cannot be
passed on to customers
D) Losses due to the untimely death of an employee in a key
position
2) Self insurance is the practice of
A) holding reserves within the firm to cover potential
losses.
B) CEO's holding large life insurance policies on
themselves, payable to the company.
C) companies in unrelated businesses forming subsidiaries
to cover their insurance needs.
D) purchasing insurance policies directly rather than
through a broker.
3) Which of the following is a consequence of transferring
risk to an insurance company?
A) An increase in stock value because risk has been
reduced.
B) A guaranteed small loss in exchange for protection
against large losses.
C) Higher rates of return because the firm is now free to
pursue high-risk projects.
D) Protection against losses at no significant cost to the
firm.
4) Self-insurance would not provide adequate protection in
which of the following circumstances?
A) Unemployment insurance for a firm that rarely lays off
employees.
B) Damage to the company's own vehicles.
C) Major ecological disasters resulting from oil spills.
D) Revenue lost because of bad weather during the peak
shopping season.
5) Which of the following types of insurance does NOT
involve a contract with an external party?
A) Property insurance
B) Life insurance
C) Directors and officers insurance
D) Self insurance
6) Which of the following should determine whether or not
the firm should purchase insurance from an outside party?
A) Only the frequency of incidents
B) The cost of the policy and the expected losses
C) Only the maximum size of incidents
D) Only the firms normal cash reserves
7) Which of the following individual situations would best
justify the cost of a life insurance policy?
A) Single income with young children
B) Single income, no dependents
C) Dual income, grown children
D) Married couple, each had substantial income before
retirement
8) Which of the following types of insurance cannot be sold
in the United States?
A) Insurance that protects against loss of revenue due to
bad weather
B) Insurance that protects a companies executives and
directors from lawsuits
C) Life insurance which pays the corporation when an employee
dies
D) All these types of insurance can be sold in the U. S.
9) Workers' compensation insurance provides coverage for
on-the-job injuries suffered by employees.
Answer: TRUE
10) Workers' compensation insurance protects employees
income in case they are laid off or fired.
Answer: FALSE
11) It is not legal for a corporation to hold life
insurance policies on its employees.
Answer: FALSE
12) Directors and officers insurance protects the company
if key personnel die or leave the firm for other opportunities.
Answer: FALSE
13) The decision to purchase insurance is justified if the
cost of the contract is less than the expected loss.
Answer: TRUE
14) How should corporations decide when to self insure
against certain risks and when to purchase insurance from outside parties?
Answer: Risks that
are a normal part of doing business and not so large that they would lead to
serious financial distress are good candidates for self-insurance. A large
courier company, for example, may routinely experience damage to its vehicles
or cause damage to other vehicles because of minor accidents.
Such incidents
are predictable cost of doing business, so the company should probably
self-insure. On the other hand, an accident that involved the death or
permanent disability of one of the company's drivers or of an outside party
would be a low probability incident that could lead to very large financial
losses, so the risk should be transferred to an insurance company.
15) (Business of Life) What guidelines should determine
whether or not an individual should buy life insurance?
Answer: The real
question is "Who needs to be protected in case I should die?" For a
single individual with no dependents or a retired couple where each has their
own source of income, the answer is probably no one, so life insurance might
not be a good choice. There are possible secondary factors such as the ability
to purchase insurance in the future or estate planning that might enter into
the decision.
On the other hand, for parents of young children or couples where
one of the spouses does not have adequate income or independent resources for
retirement, life insurance would be a wise choice. All insurance decisions,
individual or corporate, should weigh the cost of protection vs. the expected
cost of a an unfavorable event.
20.3 Managing Risk by Hedging with Forward
Contracts
1) The purpose of a hedging strategy is to
A) avoid speculation on future prices.
B) speculate that future prices will be lower than the spot
price.
C) speculate that future prices will be higher than the
spot price.
D) avoid exposure to commodity rate risk.
2) A maker of breakfast cereals has contracted to buy
100,000 bushels of wheat for $4.50 a bushel at the end of October. On the
delivery date, the spot price of wheat is $4.70 per bushel. Which of the
following is true?
A) The seller of the contract has $20,000 profit.
B) The buyer of the contract has a $20,000 loss.
C) The buyer of the contract has a $20,000 profit.
D) Both A and B are true
3) A large agribusiness firm has contracted to deliver
100,000 bushels of wheat for $4.50 a bushel at the end of October. On the
delivery date, the spot price of wheat is $4.70 per bushel. Which of the
following is true?
A) The seller of the contract has $20,000 loss.
B) The buyer of the contract has a $20,000 loss.
C) The buyer of the contract has a $20,000 profit.
D) Both A and C are true
4) The party that agrees to sell a commodity or currency in
the forward market is said to have a
A) long position.
B) short position.
C) protected position.
D) split position.
5) Swenson Oil & Gas allows its customers to
prepurchase heating oil in June for the coming winter. Swenson's customers who
take advantage of the offer
A) are speculating that fuel prices will be higher in the
future.
B) have purchased a form of call option for heating fuel.
C) are entering into a futures contract to offset the risk
of higher fuel prices during the winter.
D) are purchasing a form of insurance against fuel
shortages.
6) Swenson Oil & Gas allows its customers to
prepurchase heating oil in June for the coming winter. If Swenson does not
hedge its positions in the futures market
A) it could make unexpected profits if fuel prices decline.
B) it could suffer large losses if the winter wholesale
cost of fuel rises above the June retail price.
C) it will make normal profits if winter prices do not
change very much from the June spot price.
D) all of the above.
7) Swenson Oil & Gas allows its customers to
prepurchase heating oil in June for the coming winter. Customers who took
advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon.
Swenson hedged its position by contracting to purchase 400,000 gallons of oil
for November delivery at a price of $3.00 per gallon. If the November spot
price is $3.25 per gallon, the payoff to Swenson is
A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.
8) Swenson Oil & Gas allows its customers to
prepurchase heating oil in June for the coming winter. Customers who took
advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon.
Swenson hedged its position by contracting to purchase 400,000 gallons of oil
for November delivery at a price of $3.00 per gallon. If the November spot
price is $2.75 per gallon, the payoff to Swenson is
A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.
9) Swenson Oil & Gas allows its customers to
prepurchase heating oil in June for the coming winter. Customers who took
advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon.
Swenson hedged its position by contracting to purchase 400,000 gallons of oil
for November delivery at a price of $3.00 per gallon. If the November spot
price is $3.85 per gallon, Swenson's gross profit on the heating oil sold in
June will be
A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.
10) Hudson Valley Distributors wants to be sure it has
10,000 cases of Beaujolais Nouveau to sell next November. In January, they
enters into an agreement to buy the wine at a price of 34.62 euros per case.
Payment will be due at the end of November. They expect to sell the wine to
restaurants and retailers for $63 per case. If Hudson Valley does not hedge its
position and the exchange rate in November is $1.30 /euro, what is the gross
profit on the wine? (Round to the nearest dollar.)
A) $179,940
B) ($179,940)
C) $363,692
D) $283,800
11) Hudson Valley Distributors wants to be sure it has
10,000 cases of Beaujolais Nouveau to sell next November. In January, they
enter into an agreement to buy the wine at a price of 34.62 euros to the case.
Payment will be due at the end of November. They expect to sell the wine to
restaurants and retailers for $63 per case. Hudson Valley has hedged its
foreign exchange risk by entering into a forward contract to purchase euros in
November at $1.30/euro. If the spot exchange rate at the end of November is
$1.25/euro, the payoff to Hudson Valley for hedging is
A) $13,315.
B) $17,310.
C) ($17,310).
D) ($500).
12) Hudson Valley Distributors wants to be sure it has
10,000 cases of Beaujolais Nouveau to sell next November. In January, they
enters into an agreement to buy the wine at a price of 34.62 euros to the case.
Payment will be due at the end of November. They expect to sell the wine to
restaurants and retailers for $63 per case. Hudson Valley has hedged its
foreign exchange risk by entering into a forward contract to purchase euros in
November at $1.30/euro. If the spot exchange rate at the end of November is
$1.35/euro, Hudson Valley's gross profit will be
A) $283,800.
B) $138,415.
C) $162,630.
D) $179,940.
13) Banque de Lyon agrees to sell Golden Socks 1,000,000
euros at a price of $1.25 to the euro 6 months from today. If the spot price of
the euro in six months is $1.35
A) the payoff to Banque de Lyon is $100,000.
B) the payoff to Banque de Lyon is ($100,000).
C) the payoff to Banque de Lyon is ($135,000).
D) the payoff to Golden Socks is ($100,000).
14) Forward contracts
benefit only the customer due to a reduction in uncertainty.
Answer: FALSE
15) A purchaser of commodities who is completely hedged
with forward contracts has eliminated the risk that prices will rise before the
purchase is concluded.
Answer: TRUE
16) A purchaser of commodities who is completely hedged
with forward contracts will profit if prices fall before the purchase is
concluded.
Answer: FALSE
17) A seller of commodities who has entered into forward
contracts with customers will profit if prices fall before the purchase is
concluded.
Answer: TRUE
18) The objective of
a prudent financial manager is to eliminate all foreign exchange risk.
Answer: FALSE
19) Bowman-Daniela-Mainland is a major producer and
exporter of agricultural commodities. It has sold soy beans for future delivery
to a Japanese firm and expects to receive payments of 400 million yen in 6
months and another 400 million yen in 1 year. To lock in the exchange rates on
these two payments, BDM arranges forward contracts with an investment banker to
sell 400 million yen at $0.0110 in 6 months and $0.0115 in 1 year. What will
BDM's cash flow be in dollars from each of these transactions? How has it fixed
its revenue in dollars from the soy bean sales?
Answer: BDM will
receive $0.0110 × 400,000,000 = $4,400,000 in 6 months and $0.0115 ×
400,000,000 = $4,600,000 in 1 year. By doing so it has protected itself against
the possibility that a weaker yen would have bought fewer dollars, thereby
reducing its profit. It has also given up potential gains from a stronger yen
that would have purchased more dollars at the time of payment.
20) What motivates users of raw materials to hedge future
prices by entering into futures contracts? What is the disadvantage of this
practice?
Answer: Users of raw
materials who enter into futures contracts are fixing the price of raw
materials that they will need in the future. By doing so, they know in advance
what their costs will be and can set their own prices with confidence because
they know their materials cost with certainty.
The disadvantage to hedging is
that the firm might profit from falling prices, but has given up that
opportunity. A firm that hedges with forward contracts is essentially saying
that it is not in the business of price speculation.
21) How is an airline that sells tickets that will be used
several months in the future exposed to the risk of rising jet fuel prices? How
can it manage that risk?
Answer: When the
airline sell tickets to be used at a later date, it has entered into a futures
contract with its customers, guaranteeing the price of the flight. It has also
fixed its own revenues. If fuel prices rise, its profits will be less and it
could conceivably lose money on the flight.
By entering into forward contracts
for the purchase of fuel, it has fixed one of its major costs at the same time
it has fixed its revenue, so it can project its profits with greater confidence.
20.4 Managing Risk with Exchange-Traded Financial
Derivatives
1) Which of the following is NOT an advantage of futures
contracts?
A) They are inexpensive compared to customized forward
contracts.
B) They trade on exchanges rather than over the counter.
C) Features such as contract size and expiration date are
standardized.
D) The size and commodity can always be perfectly tailored
to form a perfect hedge.
2) A commodity such as diesel fuel for which there is no
available futures contract might be satisfactorily hedged with
A) stock index futures.
B) interest rate futures.
C) heating oil futures.
D) electricity futures.
3) Uses of future contracts include
A) eliminating uncertainty about the future cost of key
inputs.
B) eliminating uncertainty about the prices that will be
received when a commodity is ready for market.
C) speculating on future price movements of commodities
which the speculator neither uses nor produces.
D) all of the above.
4) You purchased one July futures contract of pork bellies
at $.59 per lb. One contract represents 40,000 lbs. of pork bellies. Initial
margin on the contract was 4% of the contract price with a maintenance margin of
$500. By the end of the day, the price had fallen to $.57 per lb. How much will
you be required to add to your margin account to replenish your maintenance
margin?
A) None
B) $356
C) $144
D) $32
5) You purchased one July futures contract of pork bellies
at $.59 per lb. One contract represents 40,000 lbs. of pork bellies. By the end
of the day, the price had fallen to $.57 per lb. How much did the value of your
contract change during the day?
A) It rose by $800.
B) It fell by $356.
C) It fell by $800.
D) There is no change in value until the contract expires.
6) You sold one July futures contract of pork bellies at
$.59 per lb. One contract represents 40,000 lbs. of pork bellies. By the end of
the day, the price had fallen to $.57 per lb. What was your profit or loss for
the day?
A) $800 profit
B) $356 loss
C) $800 loss
D) There is no profit or loss until the contract expires.
7) A(n) ________ gives the holder the right to buy a stated
number of shares at a specified price for a limited time.
A) stock index futures contract
B) put option
C) call option
D) interest rate futures contract
8) A(n) ________ gives the holder the right to sell a
stated number of shares at a specified price for a limited time.
A) stock index futures contract
B) put option
C) call option
D) interest rate futures contract
9) An investor would buy a ________ if he or she believes
that the price of the underlying stock or asset will fall in the near future.
A) call option
B) convertible bond
C) put option
D) futures contract to take delivery of an asset at a
future date
10) The price at which the stock or asset may be purchased
from (or sold to) the option writer is referred to as
A) intrinsic value of the option.
B) option premium.
C) open interest.
D) exercise or striking price.
11) A(n) ________ can be exercised only on the expiration
date.
A) European option
B) at-the-money option
C) short option
D) American option
12) Mayspring Corporation common stock is currently selling
for $72.00 per share. A call option on Mayspring Corporation that expires in
two months has an exercise price of $72.50. This call option is said to be
A) out-of-the-money.
B) at-the-money.
C) in-the-money.
D) covered.
13) Ahmad bought call options on Home Depot with a striking
price of $80. The option premium was $3.82. Just before the contract expired,
Home Depot stock was $82 per share. Ahmad
A) made a profit of $2.00 per share.
B) lost $3.82 per share because the option would not be
exercised.
C) made a profit of $3.82 per share.
D) lost $1.82 per share.
14) Ahmad bought put options on Verizon with a striking
price of $50. The option premium was $2.64. Just before the contract expired,
Verizon stock was at 51.39 per share. Ahmad
A) made a profit of $1.39 per share.
B) lost $2.64 per share because the option would not be
exercised.
C) lost $1.39 per share.
D) lost $1.20 per share.
15) Barco Corp. common stock is currently selling for
$36.50. A call option on Barco stock costs $.75 per share on a normal contract
of 100 shares. This option has an exercise price of $39 and expires in one
month. What is the minimum value of this option?
A) $2.50
B) $75
C) $0
D) $36.50
16) How can a currency futures contract be used as a hedge
against a potentially dramatic appreciation of a foreign currency that a U.S.
company is expecting to convert into U.S. dollars?
A) The U.S. company should sell the foreign currency using
futures contracts.
B) The U.S. company should buy more foreign currency
futures contracts than it should sell.
C) The U.S. company should buy the foreign currency using
futures contracts.
D) This is a standard business situation that would be
favorable if it were to happen, so no hedge is needed.
17) A call option on a stock is a financial instrument
defined by which of the following statements?
A) It obligates the investor holding it to sell the stock
at the specified price at the stated date in the future.
B) It obligates the investor holding it to buy the stock at
the specified price at the stated date in the future.
C) It gives the investor holding it the right, but not the
obligation, to buy the stock at the specified price at the stated date in the
future.
D) It gives the investor holding it the right, but not the
obligation, to sell the stock at the specified price at the stated date in the
future.
18) Futures contracts
A) can be used by financial managers to reduce risk.
B) provide their holder with an opportunity to buy or sell
an asset at some future time if the asset's value has changed in a manner favorable
to the futures contract holder.
C) sustain a small change in value when there is a small
change in the price of the underlying commodity.
D) have all of the characteristics stated above.
19) How can a gold futures contract be used as a hedge
against a potentially dramatic decrease in the price of the gold needed as an
input into the production of computer microprocessors?
A) The computer company should sell gold futures contracts.
B) The computer company should sell more gold futures
contracts than it should buy.
C) This is a standard business situation, which would be
favorable if it were to happen, so no hedge is needed.
D) The computer company should lower its finished product
prices now in anticipation of the decrease in the price of gold inputs.
20) Financial futures include
A) Treasury bond futures, which are the most popular of all
futures contracts in terms of contracts issued.
B) interest rate futures, which have been around the
longest.
C) stock index futures, which allow for either a cash
settlement or a stock settlement.
D) all of the above.
21) Unlike the owner of a(n) ________ contract, the owner
of a(n) ________ contract does not have to exercise it.
A) put, call
B) option, futures
C) futures, option
D) long, short
22) Erin wrote a put option on Verizon stock with a striking
price of $53 price per share. At the
expiration date, Verizon was selling for $50 per share. Which statement best
describes the course of action that Erin should or must take?
A) Erin will do nothing because the market price is lower
than the striking price.
B) Erin is obliged to buy the Verizon shares at $53, even
though the market price is $3.00 lower.
C) Erin must sell the Verizon stock for $53 per share.
D) Erin has the right to sell Verizon stock at $3.00 per
share over the market price.
23) The minimum value of a call option equals
A) exercise price - the stock price.
B) stock price - exercise price.
C) call premium - (stock price - exercise price).
D) put premium - (exercise price - stock price).
24) The owner of a large, diversified stock portfolio could
hedge against a steep decline in prices by
A) buying call options on a stock index.
B) buying put options on a stock index.
C) selling put options on a stock index.
D) buying both call and put options with the same
expiration date.
25) A futures
contract is a specialized form of a forward contract distinguished by a(n)
A) organized
exchange.
B) standardized
contract with unlimited price changes and margin requirements.
C) clearinghouse in
each futures market.
D) both A and C.
26) The term futures
margin refers to
A) the percent of
potential margin for profit associated with a futures contract.
B) the "good
faith" money the purchaser puts down to ensure that the contract will be
carried out.
C) the
interest-earning account associated with a futures contract.
D) the number of
contracts outstanding on a particular futures contract.
27) The striking
price is the
A) price paid for the
option.
B) price at which the
stock or asset may be purchased from the writer.
C) minimum value of
the option.
D) premium minus the
exercise price.
28) The term open
interest refers to the
A) total amount of
interest paid on an options margin account.
B) number of option
contracts in existence at a point in time.
C) interest
accumulated on a Treasury bond contract.
D) striking price of
an interest rate swap.
29) The popularity of
options can be explained by the use of options
A) in writing future
contracts.
B) as a type of
financial insurance.
C) to expand the set
of possible investment alternatives available.
D) both B and C.
30) A(n)________ is a financial instrument that can be used
to eliminate the effect of both favorable and unfavorable price movements.
A) convertible securities
B) call option
C) put option
D) futures contracts
31) A ________ is a contract that requires the holder to
buy or sell a stated commodity at a specified price at a specified time in the
future.
A) warrant
B) option
C) future
D) convertible contract
32) If you expect a
stock's price to rise, it would be better to purchase a call on that stock than
to purchase a put on it.
Answer: TRUE
33) The difference
between a stock's current price and the striking price of the option is the
minimum value of the option.
Answer: TRUE
34) Options can only
be purchased for individual stocks, not for funds or indexes.
Answer: FALSE
35) If you expect a
stock's price to drop, it would be better to sell a call on that stock than to
sell a put on it.
Answer: TRUE
36) A futures
contract provides the holder with the option to buy or sell a stated contract
involving a commodity or financial claim at a specified price over a stated
time period.
Answer: FALSE
37) European and
American are different types of stock options and have nothing to do with where
the options are bought and sold.
Answer: TRUE
38) Options contracts
all expire on the last trading day of the month.
Answer: FALSE
39) There is only one
day per month on which a listed option on any stock can expire.
Answer: TRUE
40) There is no
actual buying or selling that occurs with a futures contract.
Answer: FALSE
41) A call option
gives its owner the right to sell a given number of shares or some other asset
at a specified price over a given period.
Answer: FALSE
42) The seller of an
option keeps the option premium regardless of whether or not the option is ever
exercised.
Answer: TRUE
43) An options
contract gives its owner the right to buy or sell a fixed number of shares at a
specified price over a limited time period.
Answer: TRUE
44) A futures
contract is a specialized form of a forward contract distinguished by an
organized exchange which encourages confidence in the futures market by
allowing for the effective regulation of trading.
Answer: TRUE
45) The margin on a
futures contract refers to the amount of equity the investor initially paid to
purchase the futures contract.
Answer: FALSE
46) An American
option can be exercised only on the expiration date.
Answer: FALSE
47) Open interest
provides the investor with some indication of the amount of liquidity
associated with a particular option.
Answer: TRUE
48) If a call
option's exercise price is above the stock price, then the option's intrinsic
value is zero.
Answer: TRUE
49) The most you can
ever lose when you purchase a put or call option is the premium.
Answer: TRUE
50) What are the differences between forward contracts and
futures contracts? What are some advantages and disadvantages of each.
Answer: Forward
contracts can be arranged between private parties for any maturity, quantity,
commodity or financial instrument. Futures contracts have standardized
quantities, quality, and expiration dates. Forward contracts are very flexible
and can be tailored to the specific needs of the client. Because they are not
standardized, it is difficult to know their actual value, so they may be more
expensive to use than futures.
Futures are openly traded on exchanges so their
prices are set in efficient, transparent markets. The procedures to protect
both sides of the contract against defaults are well established and monitored
by the exchanges. The standardized features of future contracts also protect
buyers from deception or misunderstandings.
51) What are the rights and obligations of the buyer and
the seller of a call option on common stock?
Answer: The buyer of
a call option has the right, but not the obligation to purchase the stock at a
specified price within a specified period of time. The owner of the option will
only exercise it (buy the stock) if the striking price is below the market
price.
The seller of the option has the obligation to sell the stock to the
options owner at the striking price, even if that price is below the market
price.
52) Jorge has purchased call options on 1000 shares of
Amazon stock with a striking price of $270 per share. The option premium was
$4.00 per share.
a. Compute Jorge's profit or loss if the market value of
Amazon's stock is $280 at expiration.
b. Compute Jorge's profit or loss if the market value of
Amazon's stock is $260 at expiration.
c. Compute Jorge's profit or loss if the market value of
Amazon's stock is $272 at expiration.
Answer:
a. Profit on the stock = $10 × 1000 = $10,000. Subtracting the premium, $10,000
- $4(1000) = $6,000 profit.
b. The option will not be exercised. Jorge loses the $4,000
option premium.
c. Profit on the stock = $2 × 1000 = $2,000. Subtracting
the premium, $2,000 - $4(1000) = ($2,000) loss.
53) Annika has purchased put options on 1000 shares of
Amazon stock with a striking price of $270 per share. The option premium was
$6.00 per share.
a. Compute Annika's profit or loss if the market value of
Amazon's stock is $280 at expiration.
b. Compute Annika's profit or loss if the market value of
Amazon's stock is $260 at expiration.
c. Compute Annika's profit or loss if the market value of
Amazon's stock is $272 at expiration.
Answer:
a. The option will not be exercised because it would be better to sell the
stock in the market. Annika loses the option premium of $6,000 although the
stock is worth $10 more than the put's striking price, so she may have profits
on the stock if she owns it.
b. Annika will buy the stock for $260 if she does not
already own it, and sell it to seller of the put for $270 at a profit of
$10,000. Subtracting the option premium of $6,000 her net profit is $4,000.
c. The option will not be exercised because it would be
better to sell the stock at the market price. Annika loses the option premium
of $6,000 although she may have a profit on the stock if she owns it.
20.5 Valuing Options and Swaps
1) Which of the following variables is NOT part of the
Black-Scholes option pricing model?
A) The expected rate of return on the market
B) The current stock price
C) The strike price or exercise price
D) The time remaining before the expiration date
2) As the volatility of a stock's price increases, the
value of call options ________ and the value of put options ________.
A) decreases, increases
B) increases, increases
C) decreases, decreases
D) increases, decreases
3) As the risk free rate of return increases, the value of
call options ________ and the value of put options ________.
A) decreases, increases
B) increases, increases
C) decreases, decreases
D) increases, decreases
4) The greater a firm's dividend payout, the ________
likely it is that the stock's price will rise above the exercise price.
A) less
B) more
C) dividends have no effect on the stock's future price
D) The answer depends on the risk-free rate.
5) Assume that the current price of DEY stock is $25, that
a 6 month call option on the stock has a strike or exercise price of $27.50,
the risk free rate is 4%, and that you have calculated N(d1) as .5476
and N(d2) as .4432. Use the Black-Scholes model to calculate the price of the
option.
A) $1.74
B) $4.20
C) $1.98
D) $2.50
6) Assume that the current price of DEY stock is $27.50,
that a 6 month call option on the stock has a strike or exercise price of
$25.50, the risk free rate is 4%, and that you have calculated N(d1) as .5476
and N(d2) as .4432. Use the Black-Scholes model to calculate the price of the option.
A) $1.74
B) $4.20
C) $1.98
D) ($2.50)
7) Assume that the current price of DEY stock is $25, that
a 1 year call option on the stock has a strike or exercise price of $27.50, the
risk free rate is 4%, and that you have calculated N(d1) as .5476 and N(d2) as
.4432. Use the Black-Scholes model to calculate the price of the option.
A) $1.74
B) $4.20
C) $1.98
D) $2.50
Use the following information to answer the following
question(s).
Valuing a call option using the Black-Scholes model:
Current price of ABZ stock = $50
Exercise or strike price of the call option = $48
The maturity of the option is 0.5 years
The annualized variance in the returns on the stock is .20
The risk free rate of interest is 3% per annum
8) What is the value of d1 that should be used when calculating
the value of a call option on this stock with the Black-Scholes option pricing
model.
A) .33464
B) .07483
C) .40822
D) .01842
9) What is the value of d2 that should be used when calculating
the value of a call option on this stock with the Black-Scholes option pricing
model.
A) .33464
B) .07483
C) .40822
D) .01842
10) Assume that N(d1) = .63105 and N(d2) = .50735. Compute the value of the
call option using the Black-Scholes option pricing model.
A) $23.99
B) $7.56
C) $7.20
D) $2.00
11) When a party enters into a swap contract it agrees to
A) accept one set of payments in exchange for another.
B) exchange principals on loans with different interest
rates.
C) exchange a loan for a different loan with a different
time to maturity.
D) swap a debt obligation for an equity obligation.
12) A firm agrees to accept payments on a $1,000,000 loan
with a fixed interest rate of 8% in exchange for making the payments on a loan
with floating rate payments based on LIBOR. Payments are interest only with
principal due in 10 years. The firm will benefit
A) if LIBOR falls.
B) if LIBOR rises.
C) if Libor remains unchanged.
D) if LIBOR fluctuates randomly.
13) The seller of credit default swaps
A) agrees to exchange payments with another security if
interest rates change.
B) receives payments if the underlying security defaults.
C) is obliged to make payments if the underlying security
defaults.
D) can only sell them to owners of the underlying security.
14) Which of the following is a vehicle for controlling
exchange rate risk?
A) The purchase of a cross-rate index
B) The purchase of a LEAP
C) The purchase of a spot-rate index
D) A currency swap
15) Futures and
currency swaps eliminate unfavorable price movements, whereas options can be
used to eliminate the effect of both favorable and unfavorable price movements.
Answer: FALSE
16) As the volatility of a stock's price increases, the
value of call and put options on the stock decreases.
Answer: FALSE
17) As the length of time left until expiration increases,
the value of call and put options on the stock also increases.
Answer: TRUE
18) Currency swaps
allow the financial manager to hedge exchange rate risk over shorter periods
than options and futures contracts.
Answer: FALSE
19) A swap is
generally structured so that no money initially changes hands.
Answer: TRUE
20) A credit default
swap functions like an insurance policy against the possibility of default on a
bond or other security collateralized by debt.
Answer: TRUE
21) Assume that the current price of FGX stock is $35, that
a 6 month call option on the stock has a strike or exercise price of $33.00,
the risk free rate is 4%, and that you have calculated N(d1) as .65 and
N(d2) as .55. Use the Black-Scholes model to calculate the price of the option.
Answer: $35(.65) -
33(.9900) × .55 = $4.96
22) Assume that the current price of FGX stock is $33, that
a 6 month call option on the stock has a strike or exercise price of $35.00,
the risk free rate is 4%, and that you have calculated N(d1) as .65 and
N(d2) as .55. Use the Black-Scholes model to calculate the price of the option.
Answer: $33(.65) -
35(.9900) × .55 = $2.58
23) What are the major variables in the Black-Scholes
option pricing model and in what direction do they influence the price of call
options?
Answer: All things
equal, the value of a call increases with the price of the underlying stock.
The value of the call increases as the strike or exercise price decreases. The
value of the call increases as the time left to expiration increases.
The
expected volatility of the price and the risk-free rate of return increase the
price of the option as they increase. As the stock's dividend yield increases,
the price of the option decreases.
