Test Bank for An Introduction to Derivative Securities,

Test Bank for An Introduction to Derivative Securities, Financial Markets, and Risk Management, 1e Robert Jarrow, Arkadev Chatterjea

CHAPTER 1: Derivatives and Risk Management

MULTIPLE CHOICE

1. The following is NOT a feature of current derivatives markets:

• there is a huge variety in the number and type of derivatives contracts that are traded
• the derivatives markets are now global and measured in trillions of dollars
• commodity derivatives have emerged as the most popular kind of derivatives traded in the

new millennium

• colleges and universities now offer many kinds of derivative courses
• Wall Street firms hire graduate degree holders in finance and quantitative methods for

designing and trading derivatives

ANS: C DIF: Easy REF: 1.1 TOP: Introduction

MSC: Factual

2. A derivative security:

• is useful only for speculation
• is useful only for hedging
• is useful only for manipulating markets
• can be used for all of these purposes
• is useful for none of these purposes

ANS: D DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

3. Foreign exchange prices became volatile during the 1970s mainly because of:

• an end of the policy of fixing interest rates by the US Federal Reserve Bank
• the demise of the Bretton Woods system of fixed exchange rates
• supply shocks of the 1970s
• technology that helped us overcome the vagaries of Mother Earth
• hedge funds manipulating exchange trades

ANS: B DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

• Interest rates in the United States became volatile during the late 1970s mainly due to:
• an end of the policy of fixing interest rates by the US Federal Reserve Bank
• the demise of the Bretton Woods system of fixed exchange rates
• technological changes that enabled banks to modify interest rates
• hedge funds manipulating interest rates

ANS: A DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

5. The International Monetary Market is:

• an OTC market where money market instruments trade Stuvia.com - The Marketplace to Buy and Sell your Study Material

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Stuvia.com - The Marketplace to Buy and Sell your Study Materialb. a part of the World Bank that lends funds to developing countries

• a division of the Chicago Mercantile Exchange created for trading foreign currency futures
• a London-based market for interbank lending
• None of these answers are correct.

ANS: C DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

6. In the United States, the Great Moderation refers to:

• a 15-year-long period that began around 1900 during which the growth of real output

fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated

• the time period between 1920 and 1933 when sale, manufacture, and transportation of

alcohol was prohibited

• a time period that began in 1955 and lasted for nearly a decade during which business

cycle fluctuations declined and inflation was under control

• a time period that began after World War II and lasted for nearly a decade during the

growth of real output fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated

• a time period that began during the mid-1980s and lasted a little over two decades during

which the growth of real output fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated

ANS: E DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

7. Nobel Prize–winning economist Ronald Coase’s view is:

• arbitrage is the adhesive that holds financial markets together
• derivatives destroy financial markets via excessive speculation
• derivatives improve social welfare through better risk allocation in the economy
• firms often appear when they can lower transaction costs
• regulations and taxes cause financial innovation

ANS: D DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

• The following was NOT an example cited by Nobel laureate economist Merton Miller in support of his

view that “regulations and taxes cause financial innovation”:

• Eurobonds
• Eurodollars
• futures contracts
• swaps
• zero-coupon bonds

ANS: C DIF: Easy REF: 1.2 TOP: Financial Innovation

MSC: Factual

9. In financial markets, a coupon refers to:

• the detachable part of a stock that entitles the holder to get dividends from the company
• the interest paid on a bond on a regular basis, typically semiannually
• one side of a financial swap that entitles the holder to net payments
• the discount from the principal amount at which a zero-coupon bond is sold in the market
• a paper on whose submission a trader gets a reduction in brokerage fees

ANS: B DIF: Moderate REF: 1.3 TOP: Traded Derivative Securities Stuvia.com - The Marketplace to Buy and Sell your Study Material

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Stuvia.com - The Marketplace to Buy and Sell your Study MaterialMSC: Factual

• Who has described derivatives as “time bombs, both for the parties that deal in them and the economic

system”?

• Warren Buffett
• Ronald Coase
• Alan Greenspan
• Peter Lynch
• Merton Miller

ANS: A DIF: Easy REF: 1.3 TOP: Traded Derivative Securities

MSC: Factual

• Which of the following statements is INCORRECT?
• Derivatives trade in zero net supply markets.
• A derivatives trade is a zero-sum game in the absence of market imperfections like

transaction costs.

• Derivatives are powerful financial tools that can be used for speculation as well as

hedging.

• Derivatives have a history of always causing significant losses to any trader who trades

these contracts.

• Derivatives can help traders to reduce price risk from economic activities.

ANS: D DIF: Moderate REF: 1.3 TOP: Traded Derivative Securities

MSC: Factual

• Suppose regulators cap the maximum interest one can charge at 5 percent. Let the underlying market

interest rate be 8 percent. Charging anything lower will drive you out of business.You devise a compensatory balance scheme: for every $100 that the customer borrows, she will have to keep a certain amount with you as a compensatory balance. What should the amount of the loan and the compensatory balance be if the customer wants to borrow $5,000?

• $5,000 loan and $1,000 as compensatory balance
• $5,000 loan and $1,500 as compensatory balance
• $5,000 loan and $3,000 as compensatory balance
• $8,000 loan and $3,000 as compensatory balance
• $8,000 loan and $5,000 as compensatory balance

ANS: D DIF: Difficult REF: 1.3 TOP: Traded Derivative Securities

MSC: Applied

• The Basel Committee’s Risk Management Guidelines for Derivatives (July 1994) did NOT list which

of the following risks?

• credit risk
• legal risk
• liquidity risk
• market risk
• value-at-risk

ANS: E DIF: Easy REF: 1.5 TOP: The Regulator’s Classification of Risk MSC: Factual

• Which of the following risks can be very difficult to hedge?
• credit risk
• legal risk
• market risk Stuvia.com - The Marketplace to Buy and Sell your Study Material

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Stuvia.com - The Marketplace to Buy and Sell your Study Materiald. operations risk

• portfolio risk

ANS: D DIF: Easy REF: 1.7 TOP: Corporate Financial Risk Management MSC: Factual

• Procter & Gamble’s balance sheet suggests that which of the following is NOT a characteristic of the

company’s risk exposure or risk management practice?

• P&G is exposed to currency risk, interest rate risk, and commodity price risk.
• P&G consolidates currency risk, interest rate risk, and commodity price risk, and tries to

naturally offset them. It then tries to hedge the residual risk with derivatives.

• P&G holds some derivatives for trading purposes and trades them strategically to

maximize shareholder value.

• P&G monitors derivative positions using techniques including market value, sensitivity

analysis, and value-at-risk.

• P&G uses interest rate swaps to hedge its underlying debt obligations and enters into

certain currency interest rate swaps to hedge the company’s foreign net investments.

ANS: C DIF: Moderate REF: 1.7 TOP: Corporate Financial Risk Management MSC: Factual

• Procter & Gamble’s balance sheet suggests that which of the following is NOT a characteristic of the

company’s risk exposure or risk management practice?

• P&G manufactures and sells its products in many countries. It mainly uses forwards and

options to reduce the risk that the company’s financial position will be adversely affected by short-term changes in exchange rates.

• P&G uses futures, options, and swaps to manage price volatility of raw materials.
• P&G designates a security as a hedge of a specific underlying exposure and monitors its

effectiveness in an ongoing manner.

• P&G is exposed to significant volatility from commodity hedging activity and credit risk

exposure.

• P&G grants stock options and restricted stock awards to key managers and directors.

ANS: D DIF: Moderate REF: 1.7 TOP: Corporate Financial Risk Management MSC: Factual Stuvia.com - The Marketplace to Buy and Sell your Study Material

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