True False Questions – 25 x 2 points = 50 point total ...



Practice True False Questions for exam 1 econ 351 fall 2013

1. Suppose I am the manager of funds and I expect my firm to receive a large sum of money in the future, say in late June, 2011. Suppose also that I want to park these funds in US Treasuries when I receive them. One way to hedge against higher (Treasury) prices in the future would be to buy June 2011 futures contracts now so that I can lock in the price of Treasuries today!

A = TRUE

2. If you are a speculator and you buy a futures contract on wheat then you are a bear, since if wheat prices (both spot and expected) are lower at some future date, you can buy the futures contract back at a lower price than you sold it for and pocket the capital gain!

B = FALSE: BEARS DO NOT BUY FUTURES, THEY SELL FUTURES

3. If I go short on 10 year Treasuries by selling 5 futures contracts for 110 each, and prices rise to 112 and I close my position, then I make a profit of $10,000 (excluding transactions costs).

B = FALSE - YOU LOSE $10 K

4. Suppose I am the manger of funds and I know I need to pay out a large sum of money for Christmas (2011) bonuses. I have the cash now and I decided to buy US Treasuries and hold them until bonus time. One way to protect the value of these Treasuries is to sell Treasury futures contracts (Dec 2011 contracts).

A = TRUE

5. If you write a futures options put on crude oil then we say you are ‘bullish’ on crude oil.

A = TRUE: WRITING PUTS IS BULLISH!

6. A futures options put gives the owner

A) the right to sell the underlying futures contract.

B) the obligation to sell the underlying futures contract.

C) the right to buy the underlying futures contract.

D) the obligation to buy the underlying futures contract.

ANSWER = A

7. If you owned a gasoline station (a user of gasoline) and wanted to hedge against higher prices in the future then you could do so by buying a futures contract (in gasoline).

A = TRUE - YES, LOCK IN PRICE NOW!

The expected earning stream for Sprint for the next three years is expected to be $40,000, $50,000, and $50,000 respectively (assume the firm falls off the face of the earth in three years as we did in class). Meanwhile, interest rates are expected to be 3 % for the next three years. Given 1,000 shares of existing stock, answer the following questions:

8. The price earnings ratio for this firm is (use the first year earnings as we always do for your calculation) is:

a) between 2 and 3 b) between 3 and 4 c)greater than 4 d) none of the above

ANSWER = b) P/E RATIO IS 3.27

9. The actual stock price is above $100.

A = TRUE - PRICE IS $131.72

Suppose that AT&T inc. buys T-Mobile that basically leaves Sprint in the “dust.” As a result, the expected earnings stream of Sprint falls and is now expected to be $20,000, $20,000, and $20,000 respectively. The expected path of interest rates remain unchanged. Given this new conditions, answer the following questions:

10. The price earnings ratio for this firm is:

a) between 2 and 3 b) between 3 and 4 c)greater than 4 d) none of the above

ANSWER = a) P/E RATIO = 2.83

11. If you had previously purchased put options with a strike price of 50, then your options went from being ‘out of the money’ to being ‘in the money’

B = FALSE PRICE IS $56.57 STILL OUT OF MONEY

Futures / Futures Option Questions

Suppose you are in charge of an oil refinery which means you, as in your firm, are a user of crude oil and a producer of gasoline. As we know, both crude oil and gasoline are part of a well developed financial market so that futures and futures options markets exist that are extremely liquid for these two commodities. Suppose that the current (spot) and futures price of crude oil, per barrel, is $100. Suppose also that the current (spot) and futures price of gasoline is $3.00 per gallon. Each futures contract in oil represents 1,000 bbl and each futures contract in gasoline represents 50,000 gallons (its 42, 000 in the real world but we will use 50,000 since it is easier to work with). So you have this contract with Exxon, the user of the gasoline, to sell them 500,000 gallons of gas at the end of December. In order to produce the 500,000 gallons of gasoline you need 10,000 barrels of oil. The producer of crude oil is Saudi Arabia. Please answer the following TF questions. (WE ASSUME THAT YOU CAN TURN CRUDE INTO GAS IMMEDIATELY)

12. When you buy futures contracts in crude oil you are protecting (hedging) yourself from high (oil) prices in the future.

A = TRUE

13. Suppose you sell 10 contracts of December gasoline where the spot and futures price is $3.00 per gallon. If (spot) gas prices fall and end up at $2.80 at the end of December then your boss wants to give you a bonus, since entering the futures contract was profitable for your company (as compared to not entering a futures contract at all).

A = TRUE

14. To protect against low gas prices at the end of December, when you sell the gas, you could sell a futures contract to Exxon since Exxon has the opposite concerns in terms of the price of gasoline in the future and thus, Exxon would be willing to buy a futures contract to lock in a price (per gallon) now.

A = TRUE

15. If Saudi Arabia (the producer of the crude) wanted to lock in a price of crude to protect against low prices in the future then they would sell futures contracts in crude oil.

A = TRUE

Futures Options

We now consider the futures options market for oil and gas. Suppose futures options calls and puts are available. In particular, futures options calls and puts in oil, with a strike price of $100 per barrel, are selling for $5,000 (per contract); futures options calls and puts in gasoline, with a strike price of $3.00 per gallon are selling for $3,000 (per contract). Each futures option represents one futures contract.

16. Exxon, to hedge against high gas prices in the future, would purchase futures options puts in gasoline.

B = FALSE THEY WOULD PURCHASE FO CALLS

17. Suppose you buy 10 futures options calls in oil and 10 futures options puts in gasoline. Given that the spot price of oil at expiration is $90 per barrel of oil and $2.80 per gallon of gasoline, you did good and the boss wants to give you a bonus since it was better for you (in terms of profits = total revenue minus total costs) to play this futures options market than it was for you to ‘go naked’ and take your chances in the spot market.

A = TRUE A LOT OF WORK HERE W/O HEDGE (NAKED) TC = $900,000 TR = 1.4 MILL: PROFIT = $500,000. WITH HEDGE, PROFIT IS $20K HIGHER: TC = $80K FOR OPTIONS - RIP UP CALL, BUY OIL FOR $90, TC = $980,000. USE PUT, SELL @ STRIKE, TR = 1.5 MILL: PROFIT = $520,000. COLLECTIVELY, THE HEDGES WORKED!

18. If you are bullish on Treasuries, then you hope interest rates fall since this is consistent with being bullish on Treasuries.

A = TRUE - NEVER FORGET TO EXPLOIT THE INVERSE RELATIONSHIP BETWEEN INTEREST RATES AND BOND PRICES!

19. Futures options are more attractive relative to futures for various reasons one of which is that the amount that you can lose is limited to the premium (excluding other transactions costs) you pay for the futures option. As a result, if you lose the bet as in prices going in the wrong direction, it is always better (in terms of lower losses) to play the futures options market rather than the futures market.

B = FALSE IF YOUR BET GOES A LITTLE BIT BAD, IT IS BETTER TO PLAY FUTURES - THE WORD ALWAYS MAKES IT FALSE SINCE IT DEPENDS ON HOW BAD THE BET GOES

20. All else constant, a mortgage backed security rated BBB will sell for a lower price than a mortgage backed security rated AAA.

A = TRUE LOWER THE PRICE, THE HIGHER THE YIELD - JUNK BONDS SELL FOR REALLY LOW PRICES!

21. If you expect the price of a stock to remain relatively constant and you were playing the option market, the correct bet would be to do a long straddle, that is, buy a put and a call with the same strike price.

B = FALSE - PLAY A SHORT STRADDLE

22. All other things held constant, premiums on a call option will increase when the

A) strike price increases. B) volatility of the underlying asset falls.

C) term to maturity increases. D) (a) and (c) are both true.

ANSWER = C ALL OTHER CHOICES ARE INCORRECT

23. The premium on an April 2012 put with a strike price of 500 is higher than the premium on an April 2012 put with a strike price of 490.

ANSWER = A TRUE: I WOULD LOVE TO HAVE A PUT WITH A STRIKE PRICE OF A MILLION DOLLARS!

24. All else constant, the more volatile a firm’s stock price, the higher the premium(s) of the respective options. This notion applies to both calls and puts.

A = TRUE

25. If I own one Dec 15 (15 = strike price) put option on Intel and the spot price at expiration is $16, then the value of that put option at expiration is $100 (excluding transactions costs).

B = FALSE, THE PUT IS OUT OF THE MONEY AND NOT WORTH THE PAPER IT WAS PRINTED ON

26. All else constant, the premium on a put option is negatively related to its strike price.

B = FALSE - IT IS POSITIVELY RELATED TO ITS STRIKE PRICE

27 If I expect interest rates to rise in the future, then I should sell bonds now.

A = TRUE - THIS IS THE SAME THINGS AS SAYING, I EXPECT BOND PRICES TO FALL IN FUTURE - SELL TO AVOID THE CAPITAL LOSS: IF YOU REWORD IT, ITS A PIECE OF CAKE

28. If I write a put option, I want the price of the underlying stock to rise and if it does, then the premium on the put option that I wrote will fall. This being the case, I could reap a capital gain (profit) by buying it back at a cheaper price.

A = TRUE, EXACTLY HOW THE GAME IS PLAYED

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