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Question 1 of 10
1. Question
Which of the following statements is false regarding basis risk?
Correct
Basis risk
An agricultural producer with product to sell has a long position in the cash market. The producer has the option of selling in the cash market or selling a contract for future delivery. The key consideration for the producer is which opportunity will result in a more favorable selling price. Basis will have an impact on whether the futures contract ends up being underpriced as a result of strengthening or favorably priced as a result of weakening. Either condition will play a role in the producer’s decision.Incorrect
Basis risk
An agricultural producer with product to sell has a long position in the cash market. The producer has the option of selling in the cash market or selling a contract for future delivery. The key consideration for the producer is which opportunity will result in a more favorable selling price. Basis will have an impact on whether the futures contract ends up being underpriced as a result of strengthening or favorably priced as a result of weakening. Either condition will play a role in the producer’s decision. -
Question 2 of 10
2. Question
Regarding price of financial futures, which of the following statements is true?
Correct
Price of financial futures
The primary (and often only) component of the basis for financial futures (and most other cash- settled futures) is the cost of funds, which is expressed as interest. A change in basis is a function of changes in expected interest rates. In a period of rising interest rates, the basis would become positive, reflecting the inverse relationship between rates and prices. Conversely, the basis would become negative during a period of declining interest rates.Incorrect
Price of financial futures
The primary (and often only) component of the basis for financial futures (and most other cash- settled futures) is the cost of funds, which is expressed as interest. A change in basis is a function of changes in expected interest rates. In a period of rising interest rates, the basis would become positive, reflecting the inverse relationship between rates and prices. Conversely, the basis would become negative during a period of declining interest rates. -
Question 3 of 10
3. Question
From the statements below regarding benefits of hedges for holders of financial assets, which one seems to be the most appropriate to you?
Correct
Benefits of hedges for holders of financial assets
A hedge can protect the value of a portfolio by establishing a ceiling or floor beyond which the gain on a futures contract will offset the loss due to adverse interest rates. For example, rising long-term interest rates would cause the value of a portfolio of treasury notes to decline because of the inverse relationship between interest rates and bond prices. The holder of the notes could sell treasury note futures, which would serve as an offset to the decline in the value of the note portfolio.Incorrect
Benefits of hedges for holders of financial assets
A hedge can protect the value of a portfolio by establishing a ceiling or floor beyond which the gain on a futures contract will offset the loss due to adverse interest rates. For example, rising long-term interest rates would cause the value of a portfolio of treasury notes to decline because of the inverse relationship between interest rates and bond prices. The holder of the notes could sell treasury note futures, which would serve as an offset to the decline in the value of the note portfolio. -
Question 4 of 10
4. Question
Which of the following statements is true regarding repurchase agreement?
Correct
Repurchase agreement
A repurchase agreement is essentially a loan between parties that is secured by the value of a financial instrument, such as an equity security. The buying party agrees to accept the underlying instrument for a period of time. The selling party agrees to buy it back (repurchase it) at a specified price at the end of the agreed upon time period. The difference between the selling price and the repurchase price is the implied rate of interest, which is known as the repurchase rate.Incorrect
Repurchase agreement
A repurchase agreement is essentially a loan between parties that is secured by the value of a financial instrument, such as an equity security. The buying party agrees to accept the underlying instrument for a period of time. The selling party agrees to buy it back (repurchase it) at a specified price at the end of the agreed upon time period. The difference between the selling price and the repurchase price is the implied rate of interest, which is known as the repurchase rate. -
Question 5 of 10
5. Question
Which of the following statements is true regarding declining and advancing prices?
Correct
Declining and advancing prices
A short hedge position offers protection from a decline in pricing because the value of the futures contract will increase if prices drop, offsetting the decline in value of the cash position. However, a short hedger will incur losses if prices advance. Conversely, a long hedge position offers protection from an increase in pricing because the value of the futures contract will increase if prices rise, offsetting the higher purchase price associated with the cash position. However, a long hedger will incur losses if prices decline.Incorrect
Declining and advancing prices
A short hedge position offers protection from a decline in pricing because the value of the futures contract will increase if prices drop, offsetting the decline in value of the cash position. However, a short hedger will incur losses if prices advance. Conversely, a long hedge position offers protection from an increase in pricing because the value of the futures contract will increase if prices rise, offsetting the higher purchase price associated with the cash position. However, a long hedger will incur losses if prices decline. -
Question 6 of 10
6. Question
Which of the following statements is false regarding perfect hedge?
Correct
Perfect hedge
A perfect hedge assumes that a futures contract can be executed and that an offset with the exact same quantity and price as the underlying cash position will be available. In other words, a perfect hedge assumes that changes in one position (cash or futures) will be exactly offset by equal but opposite changes in the other. Hedges are rarely perfect since futures contracts use standardized terms. For example, a contract for ethanol is equal to 29,000 gallons (one rail car). Should the required hedge not be a multiple of 29,000, the hedge will not be perfect. Likewise, a contract may not be available at the price required due to various factors, such as a trading halt at locked limit or another type of market interruption.Incorrect
Perfect hedge
A perfect hedge assumes that a futures contract can be executed and that an offset with the exact same quantity and price as the underlying cash position will be available. In other words, a perfect hedge assumes that changes in one position (cash or futures) will be exactly offset by equal but opposite changes in the other. Hedges are rarely perfect since futures contracts use standardized terms. For example, a contract for ethanol is equal to 29,000 gallons (one rail car). Should the required hedge not be a multiple of 29,000, the hedge will not be perfect. Likewise, a contract may not be available at the price required due to various factors, such as a trading halt at locked limit or another type of market interruption. -
Question 7 of 10
7. Question
Regarding spread trade, which of the following statements is true?
Correct
Spread trade
A spread is a futures contract that includes two offsetting market positions (long and short) called legs that are entered as a single order. The goal of a spread is to benefit from the relationship between the two positions, rather than to benefit from each position separately. The underlying objective is to reduce the level of risk beyond the reduction that is possible with two separate positions. For example, an entity that creates a finished product from commodity raw materials may need to take a long position for the commodities to lock in a favorable price. And, in order to hedge against a future price decline for the finished product, a short position would be required. Both of these positions can be entered as a single spread order.Incorrect
Spread trade
A spread is a futures contract that includes two offsetting market positions (long and short) called legs that are entered as a single order. The goal of a spread is to benefit from the relationship between the two positions, rather than to benefit from each position separately. The underlying objective is to reduce the level of risk beyond the reduction that is possible with two separate positions. For example, an entity that creates a finished product from commodity raw materials may need to take a long position for the commodities to lock in a favorable price. And, in order to hedge against a future price decline for the finished product, a short position would be required. Both of these positions can be entered as a single spread order. -
Question 8 of 10
8. Question
From the statements below regarding order entry, which one seems to be the most appropriate to you?
Correct
Order entry
Most exchanges allow spreads to be entered as single orders rather than as multiple separate orders. A single order containing both legs of the trade is preferable to separate orders because the order entry and liquidation process is simplified, margin requirements are significantly lower (because of the reduction in volatility that results from offsetting short and long positions), and each leg works in relation to the other (via changes in basis).Incorrect
Order entry
Most exchanges allow spreads to be entered as single orders rather than as multiple separate orders. A single order containing both legs of the trade is preferable to separate orders because the order entry and liquidation process is simplified, margin requirements are significantly lower (because of the reduction in volatility that results from offsetting short and long positions), and each leg works in relation to the other (via changes in basis). -
Question 9 of 10
9. Question
Which of the following statements is true regarding margin requirements for hedgers and speculators?
Correct
Margin requirements for hedgers and speculators
Margins are known as performance bonds, and this term reflects their essential purpose. They are a risk management tool intended to guarantee contract performance in the event that adverse circumstances arise. Since hedgers maintain an underlying cash position, they have a greater ability to meet their obligations than speculators, whose cash positions are said to be “naked.” Spread margins are calculated using individual outright margins as a basis. These margins are adjusted to reflect the reduced risk of an order with offsetting (short and long) positions. Since outright margins are higher for speculators than they are for hedgers, the resulting spread margins are higher as well.Incorrect
Margin requirements for hedgers and speculators
Margins are known as performance bonds, and this term reflects their essential purpose. They are a risk management tool intended to guarantee contract performance in the event that adverse circumstances arise. Since hedgers maintain an underlying cash position, they have a greater ability to meet their obligations than speculators, whose cash positions are said to be “naked.” Spread margins are calculated using individual outright margins as a basis. These margins are adjusted to reflect the reduced risk of an order with offsetting (short and long) positions. Since outright margins are higher for speculators than they are for hedgers, the resulting spread margins are higher as well. -
Question 10 of 10
10. Question
Which of the following statements is false regarding value of spread order in normal market and inverted market?
Correct
Value of spread order in normal market and inverted market
In a normal market, the basis of a spread order will be negative; the longer-term futures price will be higher than the shorter-term one. The expectation of the trader is that the basis will narrow as the contract approaches expiration. In this case, a trader would buy the near-term contract (with the expectation of modestly higher prices) and sell the longer-term contract (with the expectation of lower prices). In an inverted market, the near-term contract price will be higher than the longer- term one, and the basis will be positive. The expectation of the trader is that the basis will widen as price normalizes. The trader would sell the near-term contract (with the expectation of lower prices) and buy the longer-term contract (with the expectation of higher prices).Incorrect
Value of spread order in normal market and inverted market
In a normal market, the basis of a spread order will be negative; the longer-term futures price will be higher than the shorter-term one. The expectation of the trader is that the basis will narrow as the contract approaches expiration. In this case, a trader would buy the near-term contract (with the expectation of modestly higher prices) and sell the longer-term contract (with the expectation of lower prices). In an inverted market, the near-term contract price will be higher than the longer- term one, and the basis will be positive. The expectation of the trader is that the basis will widen as price normalizes. The trader would sell the near-term contract (with the expectation of lower prices) and buy the longer-term contract (with the expectation of higher prices).