Download ACCT5341 SP05 Exam 1a 031405

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ACCT 5341 Examination 1 (Parts 1 and 2)
Dr. Jensen
Spring 2005
Students are allowed to use the following examination aids:

Calculator

Notes that you have written yourself
Students are not allowed to use the following in Part 1
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Photocopies

Books
Notes or any other materials written by other students other than File 1 and File 2 printouts that were
joint efforts between you and a partner
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Part 1 (Multiple Choice)
Choose the best answer to each question when more than one answer is correct.
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Answers are to be recorded both on the question sheet and on the answer sheet.
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The term “earnings” does not include “comprehensive earnings.”
Questions 1-20 Relate to SFAS 133 Theory and Rules
1. (05 Points) What contract below is not eligible for hedge accounting under SFAS 133?
a. Embedded call option
b. Forward rate agreement
c. Covered call
[XXXXX Paragraph 399 on Page 180 of SFAS 133.]
d. Interest rate futures
2. (05 Points) The price of a block of 10,000 options may be different than the price of a single option if all
10,000 are sold in a block. SFAS 133 requires a fair market value blockage adjustment as follows:
a. Upward
b. Downward
c. Both answers a and b above
d. Neither answers a or b above
[XXXXX Paragraph 315 beginning on Page 153 of SFAS 133.]
3. (05 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is effectively
offset by a forward cash flow hedge. The hedge may result in which of the following outcomes, relative to
having no hedge, in periods prior to the purchase of the inventory?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or
dedesignation.
[XXXXX Paragraph 30 on Page 121and Paragraph 152 beginning on Page 81 of SFAS 133. Prior to the
purchase transaction itself, gains and losses are deferred in OCI and do not affect current earnings.]
4. (05 Points) Suppose that a change in the price of gold inventory forecasted sale is effectively offset by a
forward contract cash flow hedge. The hedge may result in which of the following outcomes (relative to
having no hedge in periods prior to the sale of the inventory)?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
d. None of the above since gold cannot be a hedged item under SFAS 133.
[XXXXX Paragraph 405on Page 182 of SFAS 133. Gold price movements must be marked-to-market as
inventory. A cash flow hedge fixes the future sales price. Suppose the interim price of gold increases by
$10. Retained earnings increases when the hedged item (gold inventory) is marked to market. If the value
of the hedge (the forward contract) is deferred in OCI, the firm looks like it is doing $10 better than it really
is doing since the changes in interim prices are irrelevant if the sales price is fixed. Hence, $10 increase in
gold inventory value must be offset by a $10 decline in the value of the forward contract.]
5. (05 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is effectively
offset by a forward cash flow hedge. The hedge may result in which of the following outcomes, relative to
having no hedge, in periods prior to the purchase of the inventory?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 29c on Page 20 of SFAS 133.]
d. None of the above since this hedge does not affect reported earnings prior to the purchase transaction or
dedesignation.
6. (05 Points) Suppose that a change in the price of gold inventory forecasted purchase is effectively offset
by a forward contract cash flow hedge. The hedge may result in which of the following outcomes (relative
to having no hedge in periods prior to the puchase of the inventory)?
a. The hedge may reduce reported earnings prior to the transaction.
b. The hedge may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 29c on Page 20 of SFAS 133.]
d. None of the above since gold cannot be a hedged item under SFAS 133.
7. (05 Points) Suppose that a change in the price of a lumber inventory forecasted purchase is hedged by a
call option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the
following outcomes relative to an effective hedge in periods prior to the sale of the inventory?
a. Ineffectiveness may reduce reported earnings prior to the transaction.
b. Ineffectiveness may increase reported earnings prior to the transaction.
c. Both answers a and b are possible depending upon the direction of the hedge’s ineffectiveness.
[XXXXX Paragraph 63, especially near the top of Page 45.]
d. None of the above since ineffectiveness does not affect reported earnings prior to the sale transaction
8. (05 Points) Suppose that a change in the price of a lumber inventory forecasted sale is hedged by a put
option designated in advance as a cash flow hedge. An ineffective hedge will result in which of the
following outcomes relative to an effective hedge in periods prior to the sale of the inventory?
a. The hedge may reduce reported earnings prior to the transaction
b. The hedge may increase reported earnings prior to the transaction
c. Both answers a and b are possible depending upon the direction of the price movements.
[XXXXX Paragraph 63, especially near the top of Page 45. Illustrations can be found Paragraphs 107 and
109 beginning on Page 60 of SFAS 133.]
d. None of the above since this hedge does not affect reported earnings prior to the sale transaction.
9. (05 Points) Suppose a forward contract is used as a fair value foreign currency hedge of an asset
denominated in Mexican pesos. Hedge effectiveness is judged by comparing changes in the fair value of the
forward contract with changes in the fair value of the U.S. dollar vis-à-vis the peso. What will be the impact
of hedge ineffectiveness?
a. No impact since only cash flow hedges are subject to hedge accounting that may be judged ineffective.
b. No impact if the asset is an available-for-sale security denominated in pesos.
c. No impact if the asset is a firm commitment at a future date rather than an available-for–sale asset.
[XXXXX Footnote 22 on Page 68]
d. None of the above answers are correct.
10. (05 Points) AggiesInternational Corporation faces the risk of price declines on its forecasted sales of corn,
soybeans, and rice to Japan. Sales quantities are also uncertain. As a hedge, this company enters into a
contract (with a $0 premium) to sell as much as it wants to the Shimura Company for a contracted fixed
price and contracted proportions of all three grains per ton. In other words, for a fixed price and fixed
proportions, AggiesInternational has an option to sell as much as it wants to Shimura for a period of six
months. Can this option be a cash flow hedge under SFAS 133 rules.
a. No because the notional is not fixed, and no because the forecasted transaction is a compounding of three
grains subject to varying price risks.
b. No because the notional is not fixed even though it would otherwise be yes since the forecasted
transaction contains fixed proportion s of grains for which there is a single variable (portfolio) price per ton
that can be hedged.
[XXXX Paragraph 440a on Page 195 of SFAS 133 requires fixed quantities as well as fixed prices for the
notional. The question says sales quantities are uncertain. Paragraph 21 and other paragraphs listed under
“Forecasted Transaction” in Bob Jensen’s SFAS 133 Glossary will not allow a portfolio of transactions to
be hedged as a portfolio if the risks are not identical (within a 10% range). In this particular question,
however, the option’s specification for sales in a fixed proportion per ton converts the three grains into a
single product just as if the company was selling a single product that was being hedged. For example, bags
of animal feed comprised of the three grains could be hedged as “bags” if other conditions of the hedge
were satisfied.]
c. Yes because the notional is fixed but no, in the final analysis, because the forecasted transaction is a
compounding of three grains subject to varying price risks.
d. Yes because the notional is fixed, and yes since the forecasted transaction contains a fixed proportion of
grains for which there is a single variable portfolio price that can be hedged.
11. (05 Points) SFAS 133 limits hedge accounting to which of the following relationships?
a. Only cash flow hedges of derivative financial instruments.
b. Cash flow hedges of derivative financial instruments and certain fair value foreign-currencydenominated nonderivative instruments.
[XXXXX Para 246 on Page 131]
c. Cash flow hedges and fair value hedges that reduce market risk exposures.
d. Any derivative or nonderivative financial instrument for which there is no credit risk.
12. (05 Points) The FASB’s stated long-term objective of having all derivative and nonderivative financial
instruments booked at fair value on any reporting date would have what impact on hedge accounting?
a. This would eliminate all hedge accounting treatments for financial instruments.
[XXXXX Para 247 on Page 132]
b. This would have no impact on SFAS 133 hedge accounting rules unless the FASB changed SFAS 133.
c. This would eliminate cash flow hedges but not foreign currency hedge accounting.
d. Irrespective of possible answers above, the FASB has never declared that its long-term objective is to
require fair value reporting of all financial instruments.
13. (05 Points) Which of the following restrictions apply to an underlying of a derivative financial instrument?
a. The underlying must always be a market price or an interest rate derived from financial markets.
b. The underlying may be most any external index including official rainfall on a given day or the outcome
of a NFL game between the Green Bay Packers versus the Minnesota Vikings.
c. The underlying may be most any index that is stated in monetary terms (thereby excluding rainfall
amounts or sports scores).
[XXXXX Para 10e on Page 6 and Para 252 on Page 134]
d. None of the above answers are correct.
14. (05 Points) Which of the following cannot be an underlying according to SFAS 133?
a. Sales revenue attained by one of the contracting parties.
b. Independent appraisal of a building owned by one of the contracting parties.
c. Both of the above answers are correct.
[XXXX Para 253 on Page 134]
d. None of the above answers are correct.
15. (05 Points) SFAS 133 net settlement provisions call for settlement to be in cash or in assets easily
converted into cash. Which of the following does not meet the net price settlement test to qualify as a
derivative financial instrument in contract between Intel Corporation and General Electric?
a. Corn prices on the Chicago Board of Trade exchange.
b. The price of a common stock of Microsoft Corporation.
c. The price of the common stock of Intel Corporation.
[XXXXX Paragraph 286]
d. All of the above prices qualify since they are easily converted into cash in an organized market
exchange.
16. (05 Points) Which of the following embedded derivatives serves to disqualify the derivative from SFAS
133 accounting rules?
a. A prepayment option of a mortgage loan.
b. An interest-only strip embedded derivative.
c. A principal-only strip embedded derivative.
d. All of the above answers are correct.
[XXXXX Para 293 on Page 146, Para 310 on Page 152, Para 289 on Page 145 and Paragraph 10 on Page 5]
17. (05 Points) Which of the following types of contracts are generally excluded from SFAS 133 accounting
rules (including fair market value adjustment rules)?
a. A sales contract by Intel Corporation for microprocessors manufactured by Intel.
b. A purchase contract by Dell Corporation for microprocessors to be used in Dell computers.
c. A “regular-way” securities trade contract.
d. All of the above answers are correct.
[XXXXX Paragraph 10 on Page 5]
18. (05 Points) The “clearly-and-closely related” provisions of SFAS 133 apply mainly to which of the
following?
a. A decision as to whether an embedded derivative is subject to SFAS 133 accounting rules.
b. A decision as to whether an embedded derivative will be accounted for separately from its host contract.
[XXXXX Para 304 on Page 150]
c. The degree of ineffectiveness of an interest rate swap contract.
d. The degree of ineffectiveness of a foreign currency hedging contract..
19. (05 Points) The FASB feels that differences between forecasted transactions and firm commitments are
which of the following?
a. inconsequential and have no bearing on differences between accounting for forecasted transactions
versus firm commitments since neither appear in traditional financial statements.
b. important only in foreign currency hedge accounting differences arising from firm commitments versus
forecasted transactions.
c. important with respect to market price accounting differences arising from firm commitments versus
forecasted transactions.
[XXXXX Firm commitments do not need cash flow hedges. See Cash Flow Hedge in Bob Jensen’s SFAS
133 Glossary. Also see KPMG Example 21 on Page 229.]
d. None of the above are correct..
20. (05 Points) Creditor C loans Borrower B $10 million with an option to convert each bond into 20 shares of
Borrower B’s common stock. Assume that those shares, if acquired, would be available-for-sale and not
trading securities. Answer the following according to SFAS 133 revisions of SFAS 115 rules..
a. Borrower B has an embedded derivative that is clearly-and-closely related to the loan and the bonds
payable and the derivative are not accounted for separately.
b. Borrower B has an embedded derivative that is not clearly-and-closely related to the loan and the bonds
payable and the derivative are not accounted for separately.
c. Borrower B has an embedded derivative that is clearly-and-closely related to the loan and the bonds
payable and the derivative are accounted for separately.
d. None of the above.
[XXXXX Borrower B is the option writer. Written options are not derivative instruments according to
Paragraph 28c, 91, and 396-401 of SFAS 133. Also see Paragraph 61k on Page 43 and KPMG Page 51.]
Questions 21-30 Relate to Financial Risk Management
21. (05 Points) The term structure of interest rates describes the relationship between the:
(a) default risks of bonds and their yields to maturity.
(b) current yields of bonds and their yields to maturity.
(c) prices of bonds and their yields to maturity.
(d) maturities of bonds and their yields to maturity. XXXXX Discussed in class
22. (05 Points) The term structure theory which predicts long-term interest rates will, on average, be higher
than short-term interest rates is called:
(a) the expectations theory.
(b) the preferred habitat theory.
(c) the segmented market theory.
(d) the liquidity preference theory. XXXXX discussed in class
23. (05 Points) The forward exchange rate locked in with a forward exchange-rate contract:
(a) will always be higher than the spot exchange rate.
(b) will always be lower than the spot exchange rate
(c) may be higher or lower than the spot exchange rate. XXXXX similar to contango vs backwardation
(d) is unrelated to the current spot exchange rate.
24. (05 Points) A forward rate agreement is:
(a) a loan commitment to borrow foreign currency.
(b) a forward contract on interest rates. XXXXX Strong Page 299
(c) a forward contract on long-dated foreign currency futures.
(d) a forward loan commitment.
25. (05 Points) The process of marking futures contracts to market has the effect of:
(a) turning the futures contract into an option contract.
(b) turning the futures contract into a one-day forward contract. XXXXX
(c) understandardizing the contract’s delivery date.
(d) making the futures contract a less expensive form of hedging than the forward contract.
26. (05 Points) A person wanting to lock in an exchange rate for the payment of a foreign-currency obligation to
someone else would:
(a) sell a foreign-currency futures contract.
(b) buy a foreign-currency futures contract. XXXXX
(c) purchase a put option FX contract
(d) write a call option FX contract.
27. (05 Points) A call option can be replicated by:
(a) lending at the risk-free interest rate and selling common stock.
(b) lending at the risk-free interest rate and buying common stock.
(c) borrowing at the risk-free interest rate and selling common stock.
(d) borrowing at the risk-free interest rate and buying common stock. XXXXX
28. (05 Points) A major advantage of purchased options over futures contracts for hedging purposes is:
(a) options are cheaper.
(b) options need not be exercised. XXXXX
(c) options are more liquid.
(d) options are not legally enforceable obligations.
29. (05 Points) To set a cap on the interest rate that a company must pay for a future loan, the treasurer can:
(a) buy interest-rate call options.
(b) buy interest-rate put options. XXXXX
(c) write interest-rate put options.
(d) write interest-rate call options.
30. (05 Points) Swaptions are
(a) options on futures.
(b) options on forwards.
(c) swaps of options.
(d) options on swaps. XXXXX Strong p. 291
31. (05 Points) An investor buys 100 shares of stock at $22 and buys a DEC 20 put @ $1. This person’s
maximum loss is ____________.
a. $200
b. $500
c. $100
d. $2,0
e. None of the above. The correct answer is $_____________
ANSWER: E $300 = (100)($22 for stock) - (100)(-1+20)
32. (05 Points) In the above question, the person’s maximum possible gain is __________.
a. $475
b. $2,000
c. $2,275
d. unlimited
e. None of the above. The correct answer is $ __________
ANSWER: D
33. (05 Points) An investor buys 100 shares of stock at $24 and writes a DEC 20 put @ $1. This person’s
maximum loss is __________.
a. $2,900
b. $2,400
c. $1,900
d. $unlimited
e. None of the above. The correct answer is $_________
ANSWER: E. $4,300 = (100)(-1+20) for put plus (100)(24) for stock
34. (05 Points) An investor buys 100 shares of stock at $23 ¾ and buys one DEC 25 call @ $1. This person’s
maximum loss is ____________.
a. $475
b. $100
c. $2,375
d. Unlimited
e. None of the above. The correct answer is $_________
ANSWER: E $2,475= (100)($23.75 for stock) + (100)($1)
35. 05 Points) In the above question, the person’s gain at a $31 ¾ settlement spot price is ___________.
a. $800
b. $900
c. $575
d. unlimited
e. None of the above. The correct answer is $________
ANSWER: E: $1,375 = (100)(31.75-$23.75 for stock) + (100)(-$1+$31 ¾ -25 )
36. (05 Points) Selling stock short and simultaneously buying a call is similar to
writing a naked call.
a. writing a naked put.
b. buying a put.
c. buying two calls.
d. entering a straddle
e. None of the above. The correct answer is ___________________
ANSWER: C both are long positions
37. (05 Points) Suppose a speculator is short shares of stock. Which of the following would be the best hedge
against the short position?
a. buying a put
b. writing a put
c. buying a call
d. writing a call
e. None of the above. The correct answer is ____________
ANSWER: C short plus long
38. (05 Points) Which of the following statements is false?
a. Writing covered calls is beneficial in falling markets, but can result in opportunity losses in rising
markets.
b. Writing puts can be beneficial in rising markets, but can result in actual economic losses in falling
markets.
c. Buying calls is beneficial in falling markets, but can result in economic losses in rising markets.
d. Buying puts can be beneficial in rising or falling markets, but always involves an out-of-pocket cash
outlay.
ANSWER: C
39. (05 Points) An increase in which of the following will cause a call option to decline in value?
a. volatility
b. underlying asset price
c. striking price
d. interest rates
ANSWER: C
40. (05 Points) If someone writes a call while owning the underlying asset, the call is ___________.
a. covered
b. long
c. naked
d. cash-secured
ANSWER: A
41. (05 Points) A long position is a(n)
a. long-term investment.
b. owned asset.
c. borrowed asset.
d. a position with a paper gain.
ANSWER: B
42. (05 Points) If a person writes a covered call with a striking price of $45 and receives $3 in premium,
exercise will occur if the stock price is above ___ on expiration day.
a. $42
b. $43
c. $48
d. $50
e. None of the above. The correct answer is $___________
ANSWER: E $45
43. (05 Points) If stock is purchased at $50 and a $55 call is written for a premium of $2, the maximum
possible gain per share is _________.
a. $2
b. $5
c. $7
d. $10
ANSWER: C
44. (05 Points) If a call option with a striking price of $50 is purchased for $3 ½, the maximum loss is _____.
a. $3 ½
b. $46 ½
c. $50
d. unlimited
ANSWER: A
45. (05 Points) Which of the following strategies has the highest possible loss?
a. buying a call
b. writing a naked call
c. writing a covered call
d. buying a put
ANSWER: B
46. (05 Points) A bank's funds gap equals
a. the extent to which asset duration exceeds liability duration.
b. total assets minus total liabilities.
c. total assets minus current liabilities.
d. rate sensitive assets minus rate sensitive liabilities.
ANSWER: D
47. (05 Points) Banks usually make duration adjustments by
a. altering the left side of the balance sheet.
b. altering the right side of the balance sheet.
c. altering both sides of the balance sheet.
d. altering only the equity account.
ANSWER: A
48. (05 Points) If someone had a need to lock in a short term investment rate, they would be most likely to
a. buy T bill futures.
b. sell T bill futures.
c. buy T note futures.
d. sell T note futures.
ANSWER: A
49. (05 Points) If interest rates are expected to rise, the portfolio manager might logically
a. raise duration.
b. lower duration.
c. lower average yield.
d. lower average bond rating.
ANSWER: B
50. (05 Points) A U.S. manufacturer who sells goods abroad is most likely to hedge foreign exchange risk by
a. buying U.S. dollar futures.
b. selling U.S. dollar futures.
c. buying foreign currency futures.
d. selling foreign currency futures.
ANSWER: D
Part 2 (Essay)
Structured Financing/Transaction = the isolation of assets and obligations in a "structure" apart from the main
operations of sponsors. The structure is typically called a SPE or SPV or VIE. Its cost of capital may differ
from that of the sponsors, and the sponsors' control over the structure is generally much more limited than in the
case of unstructured financings. Often the management of the SPE or SPV is contracted to a trustee who must
be independent of the sponsors. The trustee's discretion, in turn, is limited to certain types of transactions such
a mortgage investing, project construction, project leasing, etc. The following types of structures are most
common in practice:
Required: Describe each of the following types of structures, discuss the primary arguments for and against
such a structure, and provide an example of using such a structure,
1. (10 Points) Cash Flow Structure
2. (10 Points) Derivatives Financial Instrument Structure in Lieu of an Asset Transfer
3. (10 Points) Diamond Structure
4. (10 Points) Synthetic Lease Structure