Money Banking and the Financial System 3E – Hubbard – TB

Money Banking and the Financial System 3E – Hubbard – TB

Money, Banking, and the Financial System, 3e (Hubbard/O’Brien)
Chapter 7 Derivatives and Derivative Markets

7.1 Derivatives, Hedging, and Speculating

1) In derivative markets, trade takes place in
A) assets such as bonds or common stock that derive their value from the value of the companies which issue them.
B) assets whose rates of returns must be derived from information published in financial tables.
C) assets that derive their value from underlying assets.
D) assets which are not allowed to be traded on organized exchanges.
Answer: C
Diff: 1 Page Ref: 212
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

2) Derivative instruments are
A) assets such as bonds or common stock that derive their value from the value of the companies which issue them.
B) assets whose rates of returns must be derived from information published in financial tables.
C) assets which derive their value from underlying assets.
D) computers which display real-time financial information.
Answer: C
Diff: 1 Page Ref: 212
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

3) Which of the following is NOT a benefit of derivatives?
A) risk sharing
B) guaranteed minimum profit
C) liquidity
D) information services
Answer: B
Diff: 2 Page Ref: 213
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

4) Suppose you are a manager for a company that produces grape jelly. Which of the following is the best way for you to reduce your risk?
A) acquire a derivative that increases in value if grape prices increase
B) acquire a derivative that increases in value if grape jelly prices increase
C) sell a derivative that increases in value if grape prices increase
D) sell a derivative that increases in value if grape jelly prices increase
Answer: A
Diff: 2 Page Ref: 213
Topic: hedging
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Analytical Thinking

5) The most important derivative instruments are
A) futures, options, and swaps.
B) common and preferred stocks.
C) corporate bonds.
D) government bonds.
Answer: A
Diff: 1 Page Ref: 212
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

6) Hedgers are primarily interested in
A) betting on anticipated changes in prices.
B) reducing their exposure to the risk of price fluctuations.
C) increasing market liquidity.
D) reducing the spread between bid and ask prices on bonds.
Answer: B
Diff: 1 Page Ref: 213
Topic: hedging
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

7) Investors who buy and sell oil derivatives with the hope of profiting from price changes in crude oil are known as
A) arbitrageurs.
B) speculators.
C) wildcatters.
D) profiteers.
Answer: B
Diff: 1 Page Ref: 211-212
Topic: speculation
Special Feature: Chapter Opener: You, Too, Can Buy and Sell Crude Oil … But Should You?
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
AACSB: Reflective Thinking
8) Speculators are primarily interested in
A) betting on anticipated changes in prices.
B) reducing their exposure to the risk of price fluctuations.
C) increasing market liquidity.
D) reducing the spread between bid and ask prices on bonds.
Answer: A
Diff: 1 Page Ref: 214
Topic: speculation
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

9) Profits from speculation arise because of
A) the spread between the bid and ask prices on bonds.
B) the illiquidity of markets for derivative instruments.
C) the high information costs in markets for derivative instruments.
D) disagreements among traders about future prices of a commodity or financial instrument.
Answer: D
Diff: 2 Page Ref: 214
Topic: speculation
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

10) Speculators in derivatives markets
A) reduce the efficiency of these markets.
B) are acting contrary to U.S. securities laws.
C) accept risk transferred to them by hedgers.
D) reduce the liquidity of these markets.
Answer: C
Diff: 1 Page Ref: 214
Topic: speculation
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

11) How does hedging affect the flow of funds in the financial system?
A) It reduces it since it is a sign that investors do not like risk.
B) It reduces it because it increases risk by encouraging speculation.
C) It increases it because it reduces risk thus encouraging more people to make financial investments.
D) It increases it by encouraging more speculation.
Answer: C
Diff: 2 Page Ref: 213
Topic: hedging
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking
12) If insurance is available on an activity
A) more of that activity will occur.
B) less of that activity will occur.
C) investors will be less likely to hedge.
D) it increases the risk of engaging in that activity.
Answer: A
Diff: 1 Page Ref: 213
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

13) Which of the following is NOT a result of the ability of investors to hedge?
A) increased access to funds by firms and households
B) investors are more willing to invest
C) increased risk aversion
D) slower economic growth
Answer: C
Diff: 2 Page Ref: 213
Topic: derivatives
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

14) Describe two useful purposes served by speculators in derivatives markets.
Answer: First, hedgers are able to transfer risk to speculators. In derivatives markets, as in other markets, there must be two parties to a transaction. Second, studies of derivatives markets have shown that speculators provide essential liquidity.
Diff: 2 Page Ref: 214
Topic: speculation
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

7.2 Forward Contracts

1) Using forward transactions allows
A) holders of common stock to lock in future dividend payments.
B) the federal government to stabilize fluctuations in tax receipts.
C) corporations to reduce problems arising from future fluctuations in their dividend payments.
D) both buyers and sellers to reduce risks associated with price fluctuations.
Answer: D
Diff: 2 Page Ref: 214
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

2) Spot transactions
A) involve immediate settlement.
B) may only take place in face-to-face trading.
C) take place on-the-spot, rather than on an organized exchange.
D) are relatively unimportant in financial markets.
Answer: A
Diff: 1 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

3) Forward transactions
A) allow savers and borrowers to conduct a transaction now and settle in the future.
B) allow savers and borrowers to postpone a transaction from now to the future.
C) always involve increased risk compared with spot transactions.
D) may not be conducted on organized exchanges.
Answer: A
Diff: 2 Page Ref: 214
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

4) Forward transactions would be useful to
A) a government wanting to know the size of its future debt.
B) a household wanting to reduce its future tax liability.
C) a business wanting to know the cost of its funds on future loans.
D) a business wanting to expand its operations in overseas markets.
Answer: C
Diff: 2 Page Ref: 214
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

5) Forward transactions originated in the market for
A) common stock.
B) corporate bonds.
C) government bonds.
D) agricultural and other commodities.
Answer: D
Diff: 1 Page Ref: 214
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking
6) Forward transactions
A) provide little risk sharing.
B) are very liquid.
C) have information problems.
D) are widely used by sellers of commodities, but rarely used by buyers of commodities.
Answer: C
Diff: 1 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

7) Forward contracts are often illiquid because
A) any capital gains on them are heavily taxed, making investors reluctant to sell them.
B) government regulation has not provided for a secondary market in them.
C) they generally contain terms specific to the particular buyer and seller.
D) the brokerage fees involved in buying and selling them are very high.
Answer: C
Diff: 2 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

8) The existence of counterparty risk
A) has no effect on the contracting parties.
B) is disallowed under current government regulations.
C) results in information costs for buyers and sellers when analyzing the potential creditworthiness of potential trading partners.
D) reduces the risk introduced by forward contracts.
Answer: C
Diff: 2 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

9) Forward transactions
A) provide substantial liquidity.
B) entail small information costs.
C) provide risk sharing.
D) provide reduced tax payments.
Answer: C
Diff: 2 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking
10) Forward contracts
A) are highly liquid.
B) entail small information costs.
C) provide little risk sharing.
D) are subject to default risk.
Answer: D
Diff: 2 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking

11) When talking about forward contracts, the date on which the contracted delivery must take place is called the
A) settlement date.
B) counterparty date.
C) forward date.
D) spot date.
Answer: A
Diff: 1 Page Ref: 215
Topic: forward contracts
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

12) The person on the other side of a transaction is referred to as the
A) derivator.
B) counterparty.
C) hedger.
D) speculator.
Answer: B
Diff: 1 Page Ref: 215
Topic: forward contracts
Objective: Explain what derivatives are and distinguish between using them to hedge and using them to speculate
*: Recurring
AACSB: Reflective Thinking

13) Why are forward contracts typically illiquid?
Answer: Because forward contracts usually contain terms specific to the particular buyer and seller involved in a transaction, selling the contract is difficult because a buyer would have to accept the same terms.
Diff: 2 Page Ref: 215
Topic: forward contracts
Objective: Define forward contracts and explain the role of these contracts in the financial system
*: Recurring
AACSB: Reflective Thinking