Financial Management (Chapter 20: Corporate Risk Management)

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.