Question & Answer

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 currency swap arrangement and the dollar weakens? (LO8)

Explain how the failure of a large commercial bank could cause a worldwide swap credit crisis. (LO1, LO7)

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 stocks and bonds. (LO2)

North Pier Company entered into a two-year swap agreement, which would provide fixed-rate payments for floating-rate payments. Over the next two years, interest rates declined. Based on these conditions, did North Pier Company benefit from the swap? (LO1)

Shea Savings negotiates a fixed-for-floating swap with a reputable firm in South America that has an exceptional credit rating. Shea is very confident that there will not be a default on inflow payments because of the very low credit risk of the South American firm. Do you agree? Explain. (LO3)

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 one month to five years. Comiskey has decided to engage in a fixed-for-floating swap to hedge its interest rate risk. Is Comiskey exposed to basis risk? (LO3)

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 concerned that interest rates will decline in the future. Yet, it does not want to hedge its interest rate risk because it believes interest rates may increase. Recommend a solution to Chelsea’s dilemma. (LO1, LO2)

 Describe the possible roles of securities firms in the swap market. (LO1)

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 interest rate swaps, even when they are highly exposed to interest rate risk? (LO1)

Bowling Green Savings & Loan uses shortterm deposits to fund fixed-rate mortgages. Explain how Bowling Green can use interest rate swaps to hedge its interest rate risk. (LO1)

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 (VIX). Write a short essay on the logic behind how the valuation of VIX is influenced by market uncertainty. Also support or refute the advice provided by the newsletter and offer a strategy for investing in call options on the VIX based on expectations of changes in market uncertainty. 

How would you interpret a large increase in the CBOE volatility index (VIX)? Explain why the VIX increased substantially during the Covid-19 pandemic in 2020. (LO5)

Consider the prevailing conditions that could affect the demand for stocks, including inflation, the economy, the budget deficit, the Fed’s monetary policy, political conditions, and the general mood of investors. Based on these conditions, would you consider purchasing stock index options at this time? Offer some logic to support your answer. Which factor do you think will have the biggest impact on stock index option prices? (LO2, LO5)

The price of Garner stock is $40. There is also a call option on Garner stock that is at the money, with a premium of $2.00. There is also a put option on Garner stock that is at the money, with a premium of $1.80. Why would investors consider writing this call option and this put option? Why would some investors consider buying this call option and this put option?

Explain how and why the option premiums may change in response to a surprise announcement that the Fed will increase interest rates, even if stock prices are not affected. (LO2)

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 took the following positions one year ago.

Name of S&L            Position

LaCrosse                    Sold financial futures

Stevens Point              Purchased put options on interest rate futures

Whitewater                 Did not take any position in futures

Assume that interest rates declined consistently over the last year. Which of the three S&Ls would have achieved the best performance based on this information? Explain. (LO4, LO6)

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 interest rate movements? Would futures or options on futures be more appropriate if the institution is concerned that interest rates will decline, causing a large number of mortgage prepayments? (LO4, LO6)

Describe a put option on interest rate futures. How does it differ from selling a futures contract? (LO6)

Describe a call option on interest rate futures. How does it differ from purchasing a futures contract? (LO6)

Why would a financial institution holding a stock consider buying a put option on that stock rather than simply selling it? (LO4)

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? (LO3)

Identify the factors affecting the premium paid on a put option. Describe how each factor affects the size of the premium. (LO2)

Identify the factors affecting the premium paid on a call option. Describe how each factor affects the size of the premium. (LO2)

Under what conditions would speculators sell a call option? What is the risk to speculators who sell put options? (LO3)

How do speculators use put options? Describe the conditions under which their strategy would backfire. What is the maximum loss that could occur for a purchaser of a put option? (LO3)