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Chapter 21

Risk Management

True/False

1. 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.

Difficulty: Moderate

Keywords: futures contracts

2. The main purpose of a futures clearinghouse is to provide traders with a physical location in which to trade.

Difficulty: Moderate

Keywords: futures clearinghouse

3. Treasury bond futures are the most popular of all futures contracts in terms of contracts issued.

Difficulty: Moderate

Keywords: Treasury bond futures

4. An option contract gives its owner the right to buy or sell a fixed number of shares at a specified price over a limited time period.

Difficulty: Easy

Keywords: option contract

5. 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.

Difficulty: Easy

Keywords: call option

6. If you expect a stock’s price to drop, it would be better to write a call on that stock than to write a put on it.

Difficulty: Easy

Keywords: call option

7. The term intrinsic value refers to the minimum value of the option.

Difficulty: Easy

Keywords: intrinsic value

8. Stock index options have proved so popular that they currently account for almost one-fourth of the volume of all option trading.

Difficulty: Moderate

Keywords: stock index options

9. The buyer of an option on a futures contract can achieve immunization against any unfavorable price movements, whereas the buyer of a futures contract can achieve immunization against any price movements regardless of whether they are favorable or unfavorable.

Difficulty: Moderate

Keywords: option on futures contract

10. One problem with the futures markets in the United States is that since trades occur directly between individuals, disputes often arise when trades are not properly honored.

Difficulty: Moderate

Keywords: futures markets

11. The margin on a futures contract refers to the amount of equity the investor initially paid to purchase the futures contract.

Difficulty: Easy

Keywords: futures contract

12. The initial margin for commodity futures contracts is much lower than the margin required for common stock and might be fulfilled with T-bills rather than cash. T-bills, however, are valued at only 90% of their market price for margin purposes.

Difficulty: Moderate

Keywords: initial margin, futures contract

13. Treasury bond futures are the most popular type of interest rate futures contract issued.

Difficulty: Easy

Keywords: Treasury bond futures

14. When entering into a stock index futures contract, the investor agrees to buy or sell a stated number of shares of each stock on a certain index (such as S&P 500) at a specified price at a specified time in the future.

Difficulty: Moderate

Keywords: stock index futures

15. Stock index futures make it possible for portfolio managers to reduce or eliminate their portfolios’ exposure to systematic risk.

Difficulty: Moderate

Keywords: stock index futures

16. If commissions are considered, option markets can generally be considered a “negative” sum game. That is, if profits and losses were added up, the total for all options would be negative.

Difficulty: Moderate

Keywords: options market, negative sum game

17. A warrant gives preferred stockholders the option of converting their preferred shares to shares of common.

Difficulty: Easy

Keywords: warrant, convertibles

18. There is only one day per month on which a listed option on any stock can expire.

Difficulty: Easy

Keywords: listed option expiration

19. Treasury bond options are attractive to financial managers because they allow the manager to hedge against the effects of future changes in interest rates.

Difficulty: Moderate

Keywords: Treasury bond options

20. The firm receives additional proceeds when a convertible is exercised.

Difficulty: Moderate

Keywords: convertibles

21. A futures contract provides its 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.

Difficulty: Moderate

Keywords: futures contract

22. 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.

Difficulty: Moderate

Keywords: futures contract

23. Futures and currency swaps eliminate unfavorable price movements, whereas options can be used to eliminate the effect of both favorable and unfavorable price movements.

Difficulty: Moderate

Keywords: futures and currency swaps

24. There is no actual buying or selling that occurs with a futures contract.

Difficulty: Easy

Keywords: futures contract

25. The higher the risk and stock price volatility, the greater a conversion feature will have value in the future.

Difficulty: Moderate

Keywords: convertibles

26. Financial managers can qualify for reduced initial margins on futures contracts if they are trading as a hedger rather than as a speculator.

Difficulty: Moderate

Keywords: financial managers, hedger versus speculator

27. Today financial futures, rather than commodity futures, dominate the futures markets.

Difficulty: Easy

Keywords: financial futures

28. Financial futures include interest rate futures which have been around the longest.

Difficulty: Easy

Keywords: financial futures

29. Warrants are detachable and can be separated from the security that they were originally attached to.

Difficulty: Easy

Keywords: warrants, detachability

30. Stock index futures allow for a cash settlement only.

Difficulty: Easy

Keywords: stock index futures

31. To the financial manager, the great popularity of stock index futures lies in their ability to reduce or eliminate unsystematic risk.

Difficulty: Moderate

Keywords: financial manager, stock index futures

32. 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.

Difficulty: Easy

Keywords: options contract

33. 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.

Difficulty: Easy

Keywords: call option

34. The option writer keeps the option premium regardless of whether or not the option is ever exercised.

Difficulty: Moderate

Keywords: option writer, option premium

35. An American option can be exercised only on the expiration date.

Difficulty: Easy

Keywords: American option

36. Open interest provides the investor with some indication of the amount of liquidity associated with a particular option.

Difficulty: Moderate

Keywords: open interest

37. If a call option’s exercise price is above the stock price, then the option’s intrinsic value is zero.

Difficulty: Moderate

Keywords: call option exercise price

38. The most you can ever lose when you purchase a put or call option is the premium.

Difficulty: Easy

Keywords: options, maximum loss

39. Currency swaps allow the financial manager to hedge exchange rate risk over shorter periods than options and futures contracts.

Difficulty: Moderate

Keywords: currency swaps

40. One of the most popular swaps is the interest rate currency swap.

Difficulty: Easy

Keywords: currency swap

Multiple Choice

41. According to financial theory, most investors and managers are:

a. risk seekers.

b. seeking to eliminate risk completely.

c. risk averse.

d. willing to take large, calculated risks.

Difficulty: Moderate

Keywords: financial theory and risk

42. An increase in the ___________________ would increase the value of a warrant.

a. market price of the common stock

b. exercise price

c. exercise ratio

d. both a and c

e. all of the above

Difficulty: Moderate

Keywords: warrant valuation

43. The conversion ratio increases with a decrease in the:

a. conversion price.

b. security value.

c. par value of the convertible security.

d. conversion value.

Difficulty: Moderate

Keywords: managers and risk

44. 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.

e. all of the above.

Difficulty: Moderate

Keywords: futures contract

45. 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.

Difficulty: Moderate

Keywords: futures margin

46. 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.

Difficulty: Easy

Keywords: striking price

47. 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.

Difficulty: Easy

Keywords: open interest

48. 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.

1. both b and c.
2. all of the above.

Difficulty: Moderate

Keywords: options

49. A(n)__________ is a financial instrument that can be used to eliminate the effect of both favorable and unfavorable price movements.

a. convertible security

b. warrant

c. option

d. future

Difficulty: Easy

Keywords: futures contract

50. A(n) ____________ 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

Difficulty: Easy

Keywords: futures contract

51. How can a gold futures contract be used as a hedge against a potentially dramatic increase in the price of the gold needed as a component material for the production of computer microprocessors? The computer company should:

a. sell gold futures contracts.

b. sell more gold futures contracts than it should buy.

c. buy gold futures contracts.

d. buy more gold futures contracts that it should sell.

Difficulty: Moderate

Keywords: gold futures contract, hedging strategies

52. The primary importance of having an organized exchange where futures can trade is to:

a. enforce margin requirements.

b. require a standardized contract.

c. encourage a strong primary market for futures contracts.

d. provide a central trading place, enhancing information flow and liquidity.

Difficulty: Moderate

Keywords: organized exchange, futures contract

53. 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

Difficulty: Moderate

Keywords: margin account

54. Which of the following financial futures has been around the longest?

a. Treasury bond futures

b. Stock index futures

c. Foreign exchange futures

d. Commodity futures

Difficulty: Easy

Keywords: financial futures

55. 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

Difficulty: Easy

Keywords: call option

56. 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

Difficulty: Moderate

Keywords: put option

57. 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. striking price.

Difficulty: Moderate

Keywords: striking price

58. A(n) _____________________ can be exercised only on the expiration date.

a. European option

b. at-the-money option

c. short option

d. American option

Difficulty: Easy

Keywords: European option

59. 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 $69. This call option is said to be:

a. out-of-the-money.

b. at-the-money.

c. in-the-money.

d. covered.

Difficulty: Moderate

Keywords: in-the-money call

60. 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 intrinsic value of this option?

a. $2.50

b. $75

c. $0

d. $36.50

Difficulty: Moderate

Keywords: option intrinsic value

61. When the writer of a call option owns the underlying stock or asset on which he or she writes the call, that person is said to have written a(n) ____________ call.

a. open

b. covered

c. naked

d. at-the-money

Difficulty: Moderate

Keywords: covered call

62. Acrue Company common stock is currently selling for $125 per share. You can buy a put option on this stock for $3.50 per share on a normal contract of 100 shares. This option has an exercise price of $128 and expires in five months. Compute the time value of this option.

a. $3.00

b. $3.50

c. $6.50

d. $0.50

Difficulty: Moderate

Keywords: time value of option

63. The ____________ was the first regulated central marketplace established for put and call option trading.

a. Put and Call Dealers Association

b. Over-the-Counter Market

c. AMEX

d. Chicago Board Options Exchange

Difficulty: Easy

Keywords: Chicago Board Options Exchange

64. Futures contracts have:

a. an organized exchange.

b. contracts that are standardized.

c. an unlimited pricing scheme.

1. both a and b.
2. all of the above.

Difficulty: Moderate

Keywords: futures contract

65. 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.

Difficulty: Moderate

Keywords: currency futures, hedging

66. A call option currency contract is a financial instrument defined by which of the following statements?

a. It obligates the investor holding it to sell the currency at the specified exchange rate at the stated date in the future.

b. It obligates the investor holding it to buy the currency at the specified exchange rate at the stated date in the future.

c. It gives the investor holding it the right, but not the obligation, to buy the currency at the specified exchange rate at the stated date in the future.

d. It gives the investor holding it the right, but not the obligation, to sell the currency at the specified exchange rate at the stated date in the future.

Difficulty: Moderate

Keywords: call option currency contract

67. 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.

Difficulty: Moderate

Keywords: futures contracts

68. 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.

Difficulty: Moderate

Keywords: gold futures contract

69. 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.

Difficulty: Moderate

Keywords: financial futures

70. A call option:

a. gives its owner the right to sell a given number of shares or some other asset at a specified price over a given period.

b. purchaser makes money if the price of the underlying stock or asset decreases.

c. gives its owner the right to purchase a given number of shares of stock or some other asset at a specified price over a given period.

d. does none of the above.

Difficulty: Moderate

Keywords: call option

71. Which of the following statements is true?

a. A call option is said to be out-of-the-money if the underlying stock is selling above the exercise price of the option.

b. A put option is said to be in-the-money if the underlying stock is selling below the exercise price of the option.

c. A put option is said to be out-of-the-money if the underlying stock is selling below the exercise price of the option.

d. A call option is said to be in-the-money if the underlying stock is selling below the exercise price of the option.

Difficulty: Moderate

Keywords: in-the-money put option

72. The intrinsic 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).

Difficulty: Moderate

Keywords: intrinsic value, call option

73. The intrinsic value of a put option equals:

a. exercise price - stock price.

b. stock price - exercise price.

c. call premium - (stock price - exercise price).

d. put premium - (exercise price - stock price).

Difficulty: Moderate

Keywords: intrinsic value, put option

74. The time value of a call option equals:

a. exercise price - stock price.

b. stock price - exercise price.

c. call premium - (stock price - exercise price).

d. put premium - (exercise price - stock price).

Difficulty: Moderate

Keywords: time value, call option

75. The time value of a put option equals:

a. exercise price - stock price.

b. stock price - exercise price.

c. call premium - (stock price - exercise price).

d. put premium - (exercise price - stock price).

Difficulty: Moderate

Keywords: time value of put option

76. A commodity futures contract is a financial instrument that can be defined by which of the following statements?

a. It obligates the buyer to take delivery of the commodity from the seller and the seller to deliver the commodity to the buyer holding the contract at the specified price and at the specified quality level at the stated date in the future.

b. It obligates the seller to take delivery of the commodity from the buyer and the buyer to deliver the commodity to the seller holding the contract at the specified price and the specified quality at the stated date in the future.

c. It can be tailored to the specific terms to which the buyer and the seller have agreed.

d. It requires full payment by the buyer when the contract is purchased.

Difficulty: Moderate

Keywords: commodity futures contract

77. Options are popular because:

a. call options provide a type of leverage which allows the financial manager the chance for unlimited capital gains with a very small investment.

b. they provide financial insurance, which is the most attractive feature of options to financial managers.

c. they greatly increase the set of possible investment alternatives.

d. they do all of the above.

Difficulty: Moderate

Keywords: options

78. Innovations in the options market include:

a. stock index options which allow portfolio managers to adjust unsystematic risk of their portfolios.

b. options on Treasury bond futures which involve the acquisition of a futures position rather than the delivery of actual bonds.

c. interest rate options which have extensive trading appeal.

d. all of the above.

Difficulty: Moderate

Keywords: innovations in the options market

79. In which of the following situations might a U.S. exporter acquire a put option foreign currency contract as a hedging strategy?

a. The foreign currency is expected to appreciate.

b. The foreign country interest rate is expected to remain stable.

c. The foreign currency is expected to remain stable.

d. The foreign currency is expected to depreciate.

Difficulty: Moderate

Keywords: put option foreign currency contract

80. Which of the following best describes a currency swap?

a. A currency swap is what takes place at the border when you travel to a foreign country.

b. A currency swap generally involves two companies, each of which can borrow money at a lower interest rate in its own country. They each need to use the other’s currency in their global businesses, so they borrow at home but agree to swap the loan repayment responsibilities.

c. A currency swap can only be used to hedge against foreign currency problems.

d. A currency swap generally is arranged directly by the companies involved rather than through currency swap dealers.

Difficulty: Moderate

Keywords: currency swap

81. Which of the following is an option that gives its owner the right to purchase a given number of shares of stock at a predetermined price for a specified period of time?

a. A futures contract

b. A forward contract

c. A put option

d. A call option

e. A covered option

Difficulty: Easy

Keywords: call option

82. Which of the following is an option that gives its owner the right to sell a given number of shares of stock at a predetermined price for a specified period of time?

a. A futures contract

b. A forward contract

c. A put option

d. A call option

e. A covered option

Difficulty: Easy

Keywords: put option

83. Futures contracts are used to lock in the future price of:

a. raw materials.

b. interest rates.

c. exchange rates.

d. both a & c.

e. all of the above.

Difficulty: Moderate

Keywords: futures contracts

84. “Good faith” money that the purchaser puts down to ensure that the contract will be carried out is called a(n):

a. futures margin.

b. hedge.

c. option.

d. intrinsic value.

Difficulty: Moderate

Keywords: futures margin

1. Which of the following is NOT a characteristic of a futures contract?

a. Monthly resettlement of contracts

b. Customized contracts

c. A clearinghouse in each futures market

d. Both a & b

e. All of the above

Difficulty: Moderate

Keywords: futures contract

86. Which of the following requires its holder to buy or sell the asset, regardless of what happens to its value during the interim?

a. A put option

b. A futures contract

c. A call option

d. All of the above

e. None of the above

Difficulty: Easy

Keywords: futures contract

87. Which of the following does not require its holder to buy or sell the asset, regardless of what happens to its value during the interim?

a. A put option

b. An interest rate futures contract

c. A covered option

d. A foreign exchange futures contract

e. All of the above

Difficulty: Easy

Keywords: put option

88. How can a currency futures contract be used as a hedge against a potentially dramatic depreciation 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. This is a standard business situation, so no hedge is needed.

d. The U.S. company should buy the foreign currency using futures contracts.

Difficulty: Moderate

Keywords: foreign currency futures, hedging

89. A call option is “out-of-the-money” if:

a. the underlying stock is selling above the exercise price of the option.

b. the underlying stock is selling at the same price as the exercise price of the option.

c. the underlying stock is selling below the exercise price of the option.

d. all of the above.

e. none of the above.

Difficulty: Moderate

Keywords: out-of-the-money call option

90. A put option is “in-the-money” if:

a. the underlying stock is selling above the exercise price of the option.

b. the underlying stock is selling at the same price as the exercise price of the option.

c. the underlying stock is selling below the exercise price of the option.

d. all of the above.

e. none of the above.

Difficulty: Moderate

Keywords: in-the-money put option

91. You hold a call on Chrysler Corp. common stock that expires in three months. The exercise price of the call is $48 per share; the present price of Chrysler stock is $52 per share. Which of the following terms best describes your position?

a. You are out-of-the-money.

b. You are at-the-mark.

c. You are in-the-money.

d. You are over-the-premium.

e. You missed-the-mark.

Difficulty: Moderate

Keywords: in-the-money call option

92. Where are interest rate futures traded?

a. AMEX

b. CBOE

c. NYSE

d. OTC

e. None of the above

Difficulty: Easy

Keywords: Chicago Board Options Exchange

93. 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

e. None of the above

Difficulty: Moderate

Keywords: currency swap

94. Which of the following is a vehicle for controlling interest rate risk?

a. The purchase of a Treasury bond future

b. The purchase of a naked straddle

c. A CBOT swap

d. The sale of a put

e. None of the above

Difficulty: Moderate

Keywords: Treasury bond future, controlling interest rate risk

95. Which of the following allows a portfolio manager to reduce the effects of swings in the market without the large transaction costs that are associated with trading large blocks of stock?

a. Convertible options

b. Stock index futures

c. Naked options

d. In-the-money options

e. None of the above

Difficulty: Moderate

Keywords: stock index futures

96. Using futures contracts on similar but not identical commodities is referred to as a:

a. swap.

b. cross hedge.

c. straddle hedge.

d. financial insurance.

Difficulty: Moderate

Keywords: cross hedge

97. Which of the following is a characteristic of an option?

a. Holder has the right to buy or sell a financial asset at a set price

b. More flexible than a futures contract

c. Does not establish a price obligation

d. Both b& c

e. All of the above

Difficulty: Moderate

Keywords: options

98. If a call writer does not own the underlying stock or asset on which he or she writes a call, the writer is said to have written a(n):

a. naked call.

b. out-of-the-money call.

c. cell call.

d. covered call.

e. in-the-money call.

Difficulty: Moderate

Keywords: naked call

99. Which of the following options possess the longest expiration dates?

a. Call options

b. Straddle options

c. LEAPS

d. Put options

e. CBOT’s

Difficulty: Moderate

Keywords: LEAPS

100. The amount by which an option sells at a premium above its intrinsic value is its:

a. put value.

b. cumulative premium.

c. speculative value.

d. all of the above.

e. none of the above.

Difficulty: Moderate

Keywords: speculative value

Short Answer

101. Discuss the developments that have led to dramatic growth in the trading of options.

Difficulty: Moderate

Keywords: options, market for options, growth in options trading