6.4 Options and Derivatives

Question 1

Buying a what futures contract to protect against price fluctuation of wheat would be classified as a

A. Fair value hedge
B. Cash flow hedge
C. Foreign currency hedge
D. Swap

Answer 1

B. Cash flow hedge

A cash flow hedge is an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk.

Question 2

You are currently holding a call option on a stock with an exercise price of $100. If the current stock price is $90, the intrinsic value of this option is

A. $90
B. $(10)
C. $10
D. $0

Answer 2

D. $0

The intrinsic value of a call option is the price of the underlying asset less the exercise price. If the value of the underlying is less than the exercise price of the option, the option is “out-of-the-money,” or not worth exercising. Intrinsic value cannot be less than zero. The intrinsic value of an out-of-the-money option is zero.

Question 3

A gold-mining company expects to sell 10,000 ounces of gold 6 months from today. The revenue risk of selling the gold can be hedged by

A. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.
B. Buying a gold futures contract for 5,000 ounces today that expires in 6 months and selling a gold futures contract for 5,000 ounces today that expires in 6 months.
C. Buying a gold future contract for 10,000 ounces today that expires in 6 months.
D. Selling the gold in the spot market 6 months from today.

Answer 3

A. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.

Selling a gold futures contract for 10,000 ounces today that expires in 6 months would allow the gold-mining company to lock in a selling price today for the sale of the 10,000 ounces in 6 months when the contract expires. This will hedge the revenue risk as the company pre-determined what it will get for the contract in 6 months.

Question 4

When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying

A. A hedging approach
B. Working capital management
C. Return maximization
D. Financial leverage

Answer 4

A. A hedging approach

Maturity matching, or equalizing the life of an asset and the debt instrument used to finance that asset, is a hedging approach. The basic concept is that the company has the entire life of the asset to recover the amount invested before having to pay the lender.