Question

Are the following true or false?

1. Futures prices reflect the market participants’ expectations regarding the future movements of the spot prices

2. A perfect hedge always guarantees a better payoff than an imperfect hedge

3. The higher the bond’s YTM, the higher its modified duration

4. The advantage of classical immunization over other techniques of interest rate risk management resides in the fact that once the investor immunized the portfolio, no further adjustments to the portfolio structure are necessary to assure that it remains protected against yields fluctuations

5. While implementing a stack-and-roll futures-based investment strategy on a commodity market, which is permanently in contango, the only possible way to minimize the negative rollover yield for the investor is to select the appropriate rollover timing to minimize the difference between the selling price of the outstanding futures and the purchase price of the new futures contracts

6. It is natural for the futures market for consumption assets to be constantly in backwardation

7. Securitization allows for reduction of credit risk associated with the underlying assets. This is why senior asset-backed securities frequently receive excellent credit ratings.

8. A flat spot yield curve always implies that the market expects the interest rates to remain stable in the future.

9. An interest rate swap generates a pay-off equal to that generated by a string of FRA contracts with fixing dates corresponding to swap interest exchange dates.

Answer 1

1. Futures prices reflect the market participants’ expectations regarding the future movements of the spot prices: True

Future prices are pre determined dated prices of a Future Contract. These prices are determined on investors expectations.

2. A perfect hedge always guarantees a better payoff than an imperfect hedge: False

Hedging one's position is when one has exposure to the price of an asset which is subject to fluctuation and takes a position to mitigate the fluctuation risk. Hedging is used to act as a guarantee that any losses on the futures contract will be covered; A perfect hedge is one that completely eliminates the hedger's risk. A perfect hedge does not always lead to a better outcomethan an imperfect hedge.

3. The higher the bond’s YTM, the higher its modified duration: False

Modified duration is a formula that expresses the measurable change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. To find the modified duration, all an investor needs to do is take the Macauley duration and divide it by 1 + (yield-to-maturity / number of coupon periods per year). Thus modified duration and YTM of a bond are inversely related.

4. The advantage of classical immunization over other techniques of interest rate risk management resides in the fact that once the investor immunized the portfolio, no further adjustments to the portfolio structure are necessary to assure that it remains protected against yields fluctuations: True

Immunization is a strategy that matches the durations of assets and liabilities, thereby minimizing the impact of interest rates on the net worth. Large firms and institutions have the ability protect their portfolios from exposure to interest rate fluctuations by using what is known as an immunization strategy. By using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will have virtually no impact on the value of their portfolios.