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Statements on Interest, Investment, and Contracts

1. Which of the following statements about interest rate and reinvestment rate risk is correct?

a. Variable rate securities have a high degree of interest rate risk.

b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.

c. Price risk can be eliminated by purchasing zero coupon bonds.

d. Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.

e. All of the statements above are correct.

2. Which of the following statements is most correct?
a. Forward contracts are default free.

b. Futures contracts generally trade on an organized exchange and are marked to market daily.

c. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.

d. Answers a and c are correct.

e. None of the answers above is correct.

3. A commercial bank estimates that its net income suffers whenever interest rates increase. The bank is looking to use derivatives to reduce its interest rate risk. Which of the following strategies best protects the bank against rising interest rates?

a. Buying inverse floaters.

b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.

c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.

d. Enter into a short hedge where the bank agrees to sell interest rate futures.

e. Sell some of the banks floating rate loans and use the proceeds to make fixed rate loans.

Solution Preview

1.Which of the following statements about interest rate and reinvestment rate risk is correct?
a. Variable rate securities have a high degree of interest rate risk. INCORRECT
Interest rate risk is the risk that an interest bearing asset, whether variable or fixed, has due to the volatility of interest rates. Fixed rate securities have higher interest rate risk than variable rate securities
===>b. Price risk occurs because fixed-rate debt securities lose value when interest rates rise CORRECT, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested CORRECT.
Price risk is the risk that the value of a security ...

Solution Summary

A series of statements on interest, reinvestment rate risk, and contracts are explained in detail.

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