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Questions and Answers of
Financial Accounting
How does the price of a financial futures contract change as the market price of the security it represents changes? Why?
Will speculators buy or sell Treasury bond futures contracts if they expect interest rates to increase? Explain.
Explain how purchasers of financial futures contracts can offset their position. How is their gain or loss determined? What is the maximum loss to a purchaser of a futures contract?
Explain how sellers of financial futures contracts can offset their position. How is their gain or loss determined?
Why do some financial institutions remain exposed to interest rate risk, even when they believe that the use of interest rate futures could reduce their exposure?
Write a short essay on how financial futures might reduce systemic risk, and how financial futures might increase systemic risk within financial markets.
a. "The existence of financial futures contracts allows our firm to hedge against temporary market declines without liquidating our portfolios." b. "Given my confidence in the market, I plan to use
a. Should you consider taking a position in U.S. bond index futures to hedge your investment in U.S. bonds? Explain. b. Should you consider taking a position in Japanese bond index futures to hedge
a. How could Carson use futures contracts to reduce the exposure of its cost of debt to interest rate movements? Be specific about whether it would use a short hedge or a long hedge. b. Will the
Spratt Company purchased Treasury bond futures contracts when the quoted price was 93-50. When this position was closed out, the quoted price was 94-75. Determine the profit or loss per contract,
Suerth Investments, Inc., purchased Treasury bond futures contracts when the quoted price was 95-00. When this position was closed out, the quoted price was 93-60. Determine the profit or loss per
Toland Company sold Treasury bond futures contracts when the quoted price was 94-00. When this position was closed out, the quoted price was 93-20. Determine the profit or loss per contract, ignoring
Rude Dynamics, Inc., sold T-bill futures contracts when the quoted price was 93-26. When this position was closed out, the quoted price was 93-90. Determine the profit or loss per contract, ignoring
Egan Company purchased a futures contract on Treasury bonds that specified a price of 91-00. When this position was closed out, the price of the Treasury bond futures contract was 90-10. Determine
R. C. Clark sold a futures contract on Treasury bonds that specified a price of 92-10. When the position was closed out, the price of Treasury bond futures contract was 93-00. Determine the profit or
Marks Insurance Company sold S&P 500 stock index futures that specified an index of 1690. When the position was closed out, the index specified by the futures contract was 1,720. Determine the
Describe a put option on interest rate futures. How does it differ from selling a futures contract?
Assume a savings institution has a large amount of fixed-rate mortgages and obtains most of its funds from short-term deposits. How could it use options on financial futures to hedge its exposure to
Three savings and loan institutions (S&Ls) have identical balance sheet compositions: a high concentration of short-term deposits that are used to provide long-term, fixed-rate mortgages. The S&Ls
The price of Garner stock is $40. There is a call option on Garner stock that is at the money, with a premium of $2.00. There is a put option on Garner stock that is at the money, with a premium of
Explain what backdating stock options entail. Is backdating consistent with rewarding executives who help to maximize shareholder wealth?
How are call options used by speculators? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a call option?
How are put options used by speculators? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a put option?
Under what conditions would speculators sell a call option? What is the risk to speculators who sell put options?
Identify the factors affecting the premium paid on a call option. Describe how each factor affects the size of the premium.
Identify the factors affecting the premium paid on a put option. Describe how each factor affects the size of the premium.
How can financial institutions with stock portfolios use stock options when they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more stock?
Why would a financial institution holding Hinton stock consider buying a put option on that stock rather than simply selling it?
Describe a call option on interest rate futures. How does it differ from purchasing a futures contract?
An investment newsletter suggests that because the prevailing stock market conditions are subject to much uncertainty, investors should purchase call options on the CBOE volatility index. Write a
a. How can Carson use stock options to reduce its exposure to this risk? Are there any limitations to this strategy, given that Carson will ultimately have to buy most or all of the Vinnet stock? b.
a. Assume that you wanted to take an options position to hedge your entire portfolio, which is currently valued at about $700,000. How many index option contracts should you take a position in to
a. "Our firm took a hit because we wrote put options just before the stock market crash." b. "Before hedging our stock portfolio with options on index futures, we search for the index that is most
A call option on Illinois stock specifies an exercise price of $38. Today's price of the stock is $40. The premium on the call option is $5. Assume the option will not be exercised until maturity, if
Smart Savings Bank desired to hedge its interest rate risk. It was considering two possibilities: (1) sell Treasury bond futures at a price of 94-00, or (2) purchase a put option on Treasury bond
A call option on Michigan stock specifies an exercise price of $55. Today the stock's price is $54 per share. The premium on the call option is $3. Assume the option will not be exercised until
A put option on Iowa stock specifies an exercise price of $71. Today the stock's price is $68. The premium on the put option is $8. Assume the option will not be exercised until maturity, if at all.
A put option on Indiana stock specifies an exercise price of $23. Today the stock's price is $24. The premium on the put option is $3. Assume the option will not be exercised until maturity, if at
a. Evanston Insurance Inc. has purchased shares of Stock E at $50 per share. It will sell the stock in six months. It considers using a strategy of covered call writing to partially hedge its
Purdue Savings and Loan Association purchased a put option on Treasury bond futures with a September delivery date and an exercise price of 91-16. Assume the put option has a premium of 1-32. Assume
Wisconsin Inc. purchased a call option on Treasury bond futures at a premium of 2-00. The exercise price is 92-08. If the price of the Treasury bond futures rises to 93-08, should Wisconsin Inc.
DePaul Insurance Company purchased a call option on an S&P 500 futures contract. The option premium is quoted as $6. The exercise price is $1,430. Assume the index on the futures contract becomes
Coral Inc. has purchased shares of stock M at $28 per share. It will sell the stock in six months. It considers using a strategy of covered call writing to partially hedge its position in this stock.
Bowling Green Savings & Loan uses short-term deposits to fund fixed-rate mortgages. Explain how Bowling Green can use interest rate swaps to hedge its interest rate risk.
Markus Company purchases supplies from France once a year. Would Markus be favorably affected if it establishes a currency swap arrangement and the dollar strengthens? What if it establishes a
Explain basis risk as it relates to a currency swap.
Give an example of how sovereign risk is related to currency swaps.
Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they
Explain why some companies that issue bonds engage in currency swaps. Why do they not simply issue bonds in the currency that they would prefer to use for making payments?
Bull and Finch Company wants a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and remain very high until the swap maturity date. Should it
Rider Company negotiates a forward swap to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates rise
Explain the advantage of a swap option to a financial institution that wants to swap fixed payments for floating payments.
Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Yet, the swaps were sometimes criticized for making the credit crisis worse. Why?
Explain the types of cash flow characteristics that would cause a firm to hedge interest rate risk by swapping floating-rate payments for fixed payments. Why would some firms avoid the use of
Explain why the failures of Lehman Brothers caused prices on credit default swap contracts to increase.
Explain how the Financial Reform Act of 2010 and the rules issued to implement it attempted to reduce the risk in the financial system resulting from the use of credit default swaps.
Describe the possible roles of securities firms in the swap market.
Chelsea Finance Company receives floating inflow payments from its provision of floating-rate loans. Its outflow payments are fixed because of its recent issuance of long-term bonds. Chelsea is
Comiskey Savings provides fixed-rate mortgages of various maturities, depending on what customers want. It obtains most of its funds from issuing certificates of deposit with maturities ranging from
Explain how an equity swap could allow Marathon Insurance Company to capitalize on expectations of a strong stock market performance over the next year without altering its existing portfolio mix of
Explain how the failure of a large commercial bank could cause a worldwide swap credit crisis.
A critic recently mentioned that the creation of credit default swaps caused the credit crisis in the 2008-2009 period. Write a short essay that supports or refutes this statement.
a. How could Carson use interest rate swaps to reduce the exposure of its cost of debt to interest rate movements? b. What is a possible disadvantage of Carson using the interest rate swap hedge
a. "The swaps market is another Wall Street-developed house of cards." b. "As a dealer in interest rate swaps, our bank takes various steps to limit our exposure." c. "The regulation of commercial
As a manager of a commercial bank, you have just purchased a three-year interest rate collar, with LIBOR as the interest rate index. The interest rate cap specifies a fee of 2 percent of notional
Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The notional
Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index representing the
Iowa City Bank purchases a three-year interest rate floor for a fee of 2 percent of notional principal valued at $80 million, with an interest rate floor of 6 percent, and LIBOR representing the
Explain the exchange rate system that existed during the 1950s and 1960s. How did the Smithsonian Agreement in 1971 revise it? How does today's exchange rate system differ?
How does a weak dollar affect U.S. inflation? Explain.
Explain how foreign exchange derivatives could be used by U.S. speculators to speculate on the expected appreciation of the Japanese yen.
Assume a horizontal yield curve exists. How do you think the yield curve would be affected if foreign investors in short-term securities and long-term securities suddenly anticipate that the value of
What are the consequences to a government in the Euroone when it obtains credit from the ECB?
Explain the possible signal that would be transmitted to the market if a country abandoned use of the euro.
Explain the difference between a freely floating system and a dirty float. Which type is more representative of the United States system?
Assume that European countries impose a quota on goods imported from the United States, and that the United States does not plan to retaliate. How could this affect the value of the euro? Explain.
Assume that stocks in the United Kingdom become very attractive to U.S. investors. How could this affect the value of the British pound? Explain.
Assume that Mexico suddenly experiences high and unexpected inflation. How could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory?
Assume that Switzerland has a very strong economy, placing upward pressure on both inflation and interest rates. Explain how these conditions could place pressure on the value of the Swiss franc, and
Seattle Bank just took speculative positions by borrowing Canadian dollars and converting the funds to invest in Australian dollars. Explain a possible future scenario that could adversely affect the
Recently, a government official in Europe stated that the European Central Bank needs to weaken the euro in order to improve the European economy. Write a short essay that explains the logic behind
a. "Our use of currency futures has completely changed our risk-return profile." b. "Our use of currency options resulted in an upgrade in our credit rating." c. "Our strategy to use forward
a. Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks. b. If interest rate parity holds, does this limit the effectiveness
a. How could Carson use currency futures to hedge its position? b. What is the risk of hedging with currency futures? c. How could Carson use currency options to hedge its position? d. Explain the
Use the following information to determine the probability distribution of per unit gains from selling Mexican peso futures.• Spot rate of peso is $.10.• Price of peso futures per unit is $.102
Use the following information to determine the probability distribution of net gains per unit from purchasing a call option on British pounds:Use the following information to determine the
Assume the following exchange rate quotes on British pounds:Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the exchange rates.
Assume the following information: • British pound spot rate = $1.58 • British pound one-year forward rate = $1.58 • British one-year interest rate = 11% • U.S. one-year interest rate =
Assume the following information: • Mexican one-year interest rate = 15% • U.S. one-year interest rate = 11% If interest rate parity exists, what would be the forward premium or discount on the
Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds).
Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset?
Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank's capital is less than 10 percent of its assets. How do you think this percentage would compare to
Explain how some mortgage operations by some commercial banks (along with other financial institutions) played a major role in instigating the credit crisis.
Explain how banks used credit default swaps.
What are four major sources of funds for banks? What alternatives does a bank have if it needs temporary funds? What is the most common reason that banks issue bonds?
Compare and contrast the retail CD and the negotiable CD.
Define federal funds, federal funds market, and federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday?
Explain the use of the federal funds market in facilitating bank operations.
Describe the process of borrowing from the Federal Reserve. What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve?
Explain the advantage of a bullet loan.
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