Exam 23: Managing Risk Off the Balance Sheet With Derivative Securities

Swaps and forwards are subject to contingent risk; exchange-traded futures and options are not.

A bank wishes to reduce its duration gap from 1.2 years to zero by using put options. The bank has $800 million in assets. The underlying bonds on the puts are valued at $115,000 and have a duration of four years. The put options have a delta of 0.58. How many put options are needed? Assume that there is no basis risk on the hedge.

Futures contracts are not subject to capital requirements for banks,but many forward contracts are.

The profits on a derivatives position are fixed when a bond's price falls below a certain point,but above that point the profits fall when the bond price rises. This profit profile fits which of the following positions?

In terms of direct costs,are futures or options likely to be a more expensive form of hedging? Why? In terms of opportunity costs,which is more expensive? Why?

A fixed-floating interest rate swap is called a plain vanilla swap.

The safest way to hedge a bond liability with options is to

A macrohedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable.

A purchaser of a bond call option gains if interest rates fall.

For a bond put option,the _____ the exercise price,the greater the cost of the put,and for a bond call option,the _____ the exercise price,the higher the cost of the call option.

A $995 million bank has a negative repricing gap equal to 6 percent of assets. The bank is currently paying 4.5 percent on its rate-sensitive liabilities. These rates will vary as interest rates move. The managers wish to reduce the effective repricing gap to zero with an interest rate cap or floor. A one-year cap is available with a 5 percent cap rate and a one-year floor is available at a floor rate of 4 percent. (a)Suggest a position using either the cap or the floor (but not both)that will limit the bank's interest rate risk. Explain. (b)Suppose that interest rates are volatile this year and the cap costs $275,000 and the floor costs $195,000. Suggest a collar that helps limit the bank's cost of hedging. How does the collar affect the bank's risk?

A naïve hedge is one

The price of a bond rises from 98 to par. Even if you do nothing,this would still result in an immediately recognized loss on a _____________ on a bond,and a paper gain on a bond ______________.

A bank wishes to hedge its $25 million face value bond portfolio (currently priced at 106 percent of par). The bond portfolio has a duration of five years. It will hedge with put options that have a delta of 0.67. The bond underlying the option contract has a market value of $112,000 and a duration of eight years. How many put options are needed? Assume that there is no basis risk on the hedge.

A microhedge is a

A U.S. corporation is bidding on a revenue-generating contract in England. If the corporation gets the bid,it will be paid in pounds. (A)If the managers are risk averse,can hedging increase the likelihood that the U.S. firm gets the bid? Explain. (B)In this situation,should the corporation hedge with options,futures,or forwards? Explain.

A thrift purchases a one-year interest rate floor with a floor rate of 4.23 percent from a large bank. The option has a notional principal of $1 million and costs $2,000. If in one year,interest rates are 3 percent,the thrift's net profit,ignoring commissions and taxes,was _____ ; and if in one year,interest rates were 2 percent,the thrift's net profit was _____.

The primary federal banks' regulators have established guidelines for derivatives usage at banks that includes the following: I. Banks must establish internal guidelines regarding hedging activity. II. Banks must establish trading limits. III. Banks are prohibited from using derivatives to speculate. IV. Banks must disclose large derivatives positions that may materially affect stakeholders in their financial statements.

A bond portfolio manager has a $25 million market value bond portfolio with a six-year duration. The manager believes interest rates may increase 50 basis points. Which of the following could be used to help limit his risk? I. Sell the bonds forward. II. Buy bond futures contracts. III. Buy call options on the bonds. IV. Buy put options on the bonds.

Which of the following bond option positions increase in value when interest rates increase?