Question & Answer

Blue Devil Savings and Loan Association has a large number of 10-year fixed-rate mortgages and obtains most of its funds from short-term deposits. It uses the yield curve to assess the market’s anticipation of future interest rates. It believes that expectations of future interest rates are the major force in affecting the yield curve. Assume that an upward-sloping yield curve with a steep slope exists. Based on this information, should Blue Devil consider using financial futures as a hedging technique? Explain. (LO2)

Elon Savings and Loan Association has a large number of 30-year mortgages with floating interest rates that adjust on an annual basis, and it obtains most of its funds by issuing five-year certificates of deposit. It uses the yield curve to assess the market’s anticipation of future interest rates. Elon believes that expectations of future interest rates are the major force affecting the yield curve. Assume that a downward-sloping yield curve with a steep slope exists. Based on this information, should Elon consider using financial futures as a hedging technique? Explain. (LO2) 

Explain the use of circuit breakers. (LO3)

Explain systemic risk as it relates to the futures market. Explain how the Financial Reform Act of 2010 attempted to improve the monitoring of systemic risk in the futures market and other markets. (LO4)

Why would a pension fund or insurance company consider selling stock index futures? (LO3)

Describe stock index futures. How could they be used by a financial institution that is anticipating a jump in stock prices but does not yet have sufficient funds to purchase large amounts of stock? Explain why stock index futures may reflect investor expectations about the market more quickly than stock prices. (LO3)

How might a savings and loan association use Treasury bond futures to hedge its fixed-rate mortgage portfolio (assuming that its main source of funds is short-term deposits)? Explain how prepayments on mortgages can limit the effectiveness of the hedge. (LO2)

Describe the practice of cross hedging and explain when this strategy might be used. (LO2)

Explain how the probability distribution of a financial institution’s returns is affected when it uses interest rate futures to hedge. What does this imply about its risk? (LO2)

Explain the difference between a long hedge and a short hedge used by financial institutions. When is a long hedge more appropriate than a short hedge? (LO2)

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? (LO2)

Assume a financial institution has more rate-sensitive liabilities than rate-sensitive assets. Would it be more likely to be adversely affected by an increase or a decrease in interest rates? Should it purchase or sell interest rate futures contracts so as to hedge its exposure? (LO2)

Assume a financial institution has more rate-sensitive assets than rate-sensitive liabilities. Would it be more likely to be adversely affected by an increase or decrease in interest rates? Should it purchase or sell interest rate futures contracts in order to hedge its exposure? (LO2)

Explain how sellers of financial futures contracts can offset their position. How is their gain or loss determined? (LO1)

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? (LO1)

Will speculators buy or sell Treasury bond futures contracts if they expect interest rates to increase? Explain. (LO2)

Explain why some futures contracts may be more suitable than others for hedging exposure to interest rate risk. (LO2)

How does the price of a financial futures contract change as the market price of the security it represents changes? Why? (LO1)

Describe the general characteristics of a futures contract. How does a clearinghouse facilitate the trading of financial futures contracts? (LO1)

Some critics argue that insider trading should not be illegal, because it allows market prices to more quickly reflect the inside information. Write a short essay that supports or refutes this opinion.

Explain how and why high-frequency trading affects spreads. (LO3)

Explain how some high-frequency traders use a form of front running to capitalize on faster access to specific markets. (LO3)

Describe the flash crash on May 6, 2010, and explain why it caused so much concern among investors and regulators. (LO3)

Explain the strategy of high-frequency trading firms. Describe the typical time horizon of an investment that is relevant to highfrequency traders and explain how it varies from the time horizons of other institutional investors. (LO3)

Explain how the Galleon Fund case led to stronger enforcement against insider trading. (LO4)