LOS d: Demonstrate the advantages of using futures instead of cash market instruments to alter portfolio risk.

Q1. Which of the following is an advantage of using financial futures for asset allocation purposes instead of the cash market securities? Futures:

A)   offer time savings.

B)   can be tailored to an investor's particular requirements.

C)   are traded over-the-counter which eliminates the market impact of large transactions.

Q2. Which of the following statements about bond portfolio management is least accurate?

A)   A portfolio managers sold a floor to finance the purchase of a cap in anticipation of higher interest rates on a floating-rate liability.

B)   A portfolio manager with a $50 million face value in bonds and a futures contract with $100,000 face value should use 500 futures contracts according to the Face Value Naive model.

C)   To increase the duration of a bond portfolio through futures, the portfolio manager should sell futures contracts.

Q3. Which of the following is NOT an advantage of using financial futures for asset allocation?

A)   More precise hedging.

B)   Less portfolio disruption.

C)   Time savings.

Q4. Which of the following is NOT an advantage of using futures instead of cash market instruments to alter portfolio risk?

A)   Higher margin requirements.

B)   Lower transaction costs.

C)   Greater leverage opportunities.

Q5. John Hanes serves as a portfolio manager for Stackhouse Investments. One of his clients, the Red Wing Corporation, holds a $50 million face value position in a T-bill that matures in 182 days on March 21 (today is September 21). Red Wing also owns a $100 million position in a floating rate note (FRN) that matures in one year, pays LIBOR plus 25bp and has interest rate reset dates on December 21, March 21, and June 21. Red Wing has indicated that they need to sell the T-bill investment sooner than anticipated to fund an unexpected series of cash outflows.

Which of the following positions would effectively shorten the maturity of your client's Treasury bill investment and hedge your client against adverse movements in interest rates until the sale date?

A)   Sell 50 T-bill futures contracts.

B)   Buy 50 T-bill futures contracts.

C)   Sell 500 T-bill futures contracts.

Q6. Assuming interest rates rise, which of the following CORRECTLY describes the outcome regarding the ultimate disposal of the T-bill?

A)   The T-bill will lose value, but the short T-bill futures contracts will gain in value to offset the loss.

B)   The T-bill futures contract will lose value, but the Treasury bill will gain in value to offset the loss.

C)   The holdings of T-bill futures contracts will have to be reduced (rebalanced) in order to maintain the current hedged relationship.

Q7. Which of the following is a methodology that could be employed to convert your client's FRN to a one-year fixed r ate structure?

A)   Enter into an interest rate collar.

B)   Purchase an interest rate cap.

C)   Enter into a one-year, quarterly, receive-fixed interest rate swap.

Q8. Which of the following is NOT an advantage of using interest rate futures instead of cash market instruments to alter portfolio risk?

A)   Margin requirements are lower, allowing for greater leverage.

B)   Futures can be customized to match any specific customer needs.

C)   Transaction costs are lower.

Q9. Which of the following is NOT an advantage of using financial futures for asset allocation purposes instead of the cash market securities?

A)   Large orders have a very small market impact in the futures market.

B)   Futures are priced exactly the same as the underlying asset but are more liquid.

C)   Futures have lower brokerage fees.

Q10. Which of the following is an advantage of using futures instead of cash market instruments to alter portfolio risk?

A)   Futures provide higher returns than cash market instruments.

B)   Transaction costs for trading futures are lower than trading in the cash market.

C)   Futures can be customized to match any specific customer needs.

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Q1. Which of the following is an advantage of using financial futures for asset allocation purposes instead of the cash market securities? Futures:

A)   offer time savings.

B)   can be tailored to an investor's particular requirements.

C)   are traded over-the-counter which eliminates the market impact of large transactions.

Correct answer is A)

It will take less time to execute the asset allocation shift using futures than with buying and selling individual stocks and bonds.

Q2. Which of the following statements about bond portfolio management is least accurate?

A)   A portfolio managers sold a floor to finance the purchase of a cap in anticipation of higher interest rates on a floating-rate liability.

B)   A portfolio manager with a $50 million face value in bonds and a futures contract with $100,000 face value should use 500 futures contracts according to the Face Value Naive model.

C)   To increase the duration of a bond portfolio through futures, the portfolio manager should sell futures contracts.

Correct answer is C)

To increase the duration of a bond portfolio through futures, the portfolio manager should buy futures contracts.

Q3. Which of the following is NOT an advantage of using financial futures for asset allocation?

A)   More precise hedging.

B)   Less portfolio disruption.

C)   Time savings.

Correct answer is A)

Using financial futures contracts will save time and cause less portfolio disruption. However, futures contracts expose the manager to basis risk, wherein the futures contract and the portfolio are not perfectly correlated, leading to return differences between the futures position and the underlying exposure that is being replicated.

Q4. Which of the following is NOT an advantage of using futures instead of cash market instruments to alter portfolio risk?

A)   Higher margin requirements.

B)   Lower transaction costs.

C)   Greater leverage opportunities.

Correct answer is A)

Lower margin requirements are one of the advantages of using futures instead of cash market instruments. The margin requirements are lower for futures, which allows for greater leverage.

Q5. John Hanes serves as a portfolio manager for Stackhouse Investments. One of his clients, the Red Wing Corporation, holds a $50 million face value position in a T-bill that matures in 182 days on March 21 (today is September 21). Red Wing also owns a $100 million position in a floating rate note (FRN) that matures in one year, pays LIBOR plus 25bp and has interest rate reset dates on December 21, March 21, and June 21. Red Wing has indicated that they need to sell the T-bill investment sooner than anticipated to fund an unexpected series of cash outflows.

Which of the following positions would effectively shorten the maturity of your client's Treasury bill investment and hedge your client against adverse movements in interest rates until the sale date?

A)   Sell 50 T-bill futures contracts.

B)   Buy 50 T-bill futures contracts.

C)   Sell 500 T-bill futures contracts.

Correct answer is A)

Since the client owns $50 million of face value of the T-bill, we should sell 50 December T-bill futures contracts. We sell 50 contracts because each contract controls a $1 million T-bill with a 90-92 day maturity upon expiration of the futures.

Q6. Assuming interest rates rise, which of the following CORRECTLY describes the outcome regarding the ultimate disposal of the T-bill?

A)   The T-bill will lose value, but the short T-bill futures contracts will gain in value to offset the loss.

B)   The T-bill futures contract will lose value, but the Treasury bill will gain in value to offset the loss.

C)   The holdings of T-bill futures contracts will have to be reduced (rebalanced) in order to maintain the current hedged relationship.

Correct answer is A)

This position will also hedge your client against adverse movements in interest rates should he decide to sell before the expiry of the T-bill futures. If interest rates rise, the T-bill will lose value, but the short T-bill futures position will gain value to offset this loss.

Q7. Which of the following is a methodology that could be employed to convert your client's FRN to a one-year fixed r ate structure?

A)   Enter into an interest rate collar.

B)   Purchase an interest rate cap.

C)   Enter into a one-year, quarterly, receive-fixed interest rate swap.

Correct answer is C)

The swap will have a single fixed rate that will be received on a quarterly basis. The LIBOR payments from the swap will cancel with the LIBOR receipts from the client’s FRN. The net cash flow will be the swap fixed rate plus 25bp.

Q8. Which of the following is NOT an advantage of using interest rate futures instead of cash market instruments to alter portfolio risk?

A)   Margin requirements are lower, allowing for greater leverage.

B)   Futures can be customized to match any specific customer needs.

C)   Transaction costs are lower.

Correct answer is B)         

Futures are standardized contracts as opposed to forward contracts and cannot be customized to match any specific customer needs.

Q9. Which of the following is NOT an advantage of using financial futures for asset allocation purposes instead of the cash market securities?

A)   Large orders have a very small market impact in the futures market.

B)   Futures are priced exactly the same as the underlying asset but are more liquid.

C)   Futures have lower brokerage fees.

Correct answer is B)         

Futures are not priced exactly the same as the underlying cash asset. The difference between the two prices is the basis which is normally not equal to zero.

Q10. Which of the following is an advantage of using futures instead of cash market instruments to alter portfolio risk?

A)   Futures provide higher returns than cash market instruments.

B)   Transaction costs for trading futures are lower than trading in the cash market.

C)   Futures can be customized to match any specific customer needs.

Correct answer is B)         

There are three main advantages to using futures over cash market instruments. All three advantages are derived from the fact that there are low transactions costs and a great deal of depth in the futures market.

Compared to cash market instruments, futures:

1. Are more liquid.
2. Are less expensive.
3. Make short positions more readily obtainable, because the contracts can be more easily shorted than an actual bond.

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