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Hull: Options, Futures, and Other Derivatives, Ninth Edition

Chapter 9: OIS Discounting, Credit Issues, and Funding Costs


Multiple Choice Test Bank: Questions with Answers
1. Prior to the credit crisis that started in 2007 which of the following was used
by derivatives traders for the discount rate when derivatives were valued
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate
Answer: B
Derivatives markets used LIBOR as the discount rate pre-crisis.
2. Since the credit crisis that started in 2007 which of the following have
derivatives traders used as the risk-free discount rate for collateralized
transactions
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate
Answer: D
Derivatives markets have used the OIS rate as the discount rate for
collateralized transactions since the crisis.
3. Which
A.
B.
C.

of the following is true


OIS rates are less than the corresponding LIBOR/swap rates
OIS rates are greater than corresponding LIBOR/swap rates
OIS rates are sometimes greater and sometimes less than LIBOR/swap
rates
D. OIS rates are equivalent to one-day LIBOR rates
Answer: A

OIS rates are less than LIBOR /swap rates when both have the same maturity.

4. Which of the following describes a 3-month overnight indexed swap (OIS)?


A. A fixed rate is exchanged for the overnight rate every day for three
months
B. LIBOR is exchanged for the overnight rate every day for three months
C. The arithmetic average of overnight rates is exchanged for a fixed rate
at the end of three months

D. The geometric average of overnight rates is exchanged for a fixed rate


at the end of three months
Answer: D
The OIS rate is the rate exchanged for the geometric average of overnight rates.
In the U.S. the overnight rate is the fed funds rate
5. Suppose that OIS rates for all maturities are 2.5% and swap rates for all
maturities are 3%. Which of the following is true?
A. Forward LIBOR rates are greater when OIS discounting is used than
when LIBOR discounting is used
B. Forward LIBOR rates are less when OIS discounting is used than when
LIBOR discounting is used
C. Forward LIBOR rates are the same for both OIS discounting and LIBOR
discounting
D. Either A or B can be true
Answer: C
When the yield curves are flat, all forward LIBOR rates are 3% regardless of
whether OIS or LIBOR discounting is used. This is because, when all forward
LIBOR rates equal 3%, all exchanges on all swaps are worth zero regardless of
the discount rate used.
6. CVA stands for
A. Collateral value adjustment
B. Credit value adjustment
C. Credit value agreement
D. Collateral value agreement
Answer: B
CVA stands for credit value adjustment
7. In a fully collateralized transaction which of the following leads to a pricing
adjustment
A. The rate paid on cash collateral is the fed funds rate
B. The rate paid on cash collateral is greater than the fed funds rate
C. The rate paid on cash collateral is less than the fed funds rate
D. Both B and C
Answer: D
If the rate paid on cash collateral is different from the fed funds rate then an
adjustment is necessary. The OIS rate is linked to the fed funds rate and is the
rate used for discounting fully collateralized transactions.
8. When
A.
B.
C.

a banks borrowing rate goes up, which of the following is true


DVA increases so that the banks profit goes down
DVA increases so that the banks profit goes up
DVA declines so that the banks profit goes down

D. DVA declines so that the banks profit goes up


Answer: B
The bank is considered more likely to default. Its DVA therefore increases and
this increases its profit because it is then considered more likely that it will
default and not have to meet derivatives obligations.
9. In October 2008 the three-month LIBOR-OIS spread rose to
A. 231 basis points
B. 364 basis points
C. 450 basis points
D. 520 basis points
Answer: B
In October 2008 the three-month LIBOR-OIS spread rose to 364 basis point, a
record.
10.As a bank`s borrowing rate increases, which of the following is true if a bank
calculates FVA
A. FVA increases
B. FVA declines
C. FVA stays the same
D. FVA may increase or decline.
Answer: A
FVA is the funding value adjustment. As borrowing costs increase it costs the
bank more to fund its operations and FVA increases. (In theory, as explained in
the text, funding value adjustments should not be made but in practice they are
often made.)

11.Which of the following is true


A. CVA and DVA can be calculated deal by deal
B. CVA and DVA must both be calculated for the whole portfolio a bank
has with a counterparty
C. CVA can be calculated deal by deal but DVA must be calculated for a
portfolio
D. DVA can be calculated deal by deal but CVA must be calculated for a
portfolio
Answer: B
Because of netting, all derivatives in a portfolio are considered to be a single
derivative in the event of a default. CVA which measures the cost of a
counterparty default and DVA which measures the benefit of the bank defaulting
must therefore be calculated on a portfolio basis.

12.Which of the following is true when a bank uses OIS discounting for valuing a
LIBOR-for-fixed swap
A. The LIBOR/swap zero curve is calculated before the OIS zero curve
B. The OIS zero curve is calculated before the LIBOR/swap zero curve
C. The swap is valued using OIS forward rates and OIS discounting
D. The forward rates are calculated from the banks borrowing costs
Answer: B
First the OIS zero curve is calculated. LIBOR forward rates are then calculated so
that all swaps when entered into at mid-market swap rates have zero value
13.It is assumed that a company can default after one year or after two years.
The probability of default at each time is 1.5%. The present value of the
expected loss to a bank on a derivatives portfolio if the company defaults
after one year is estimated to be $1 million. The present value of the
expected loss if it defaults after two years is estimated to be $2 million.
Which of the following is the banks CVA ?
A. $3,000,000
B. $300,000
C. $450,000
D. $150,000
Answer: C
The present value of the expected loss is 0.015$1,000,000 +
0.015$2,000,000 or $450,000. This is the CVA.
14.Accountants like to value a derivatives portfolio at
A. The bid price
B. The offer price
C. The exit price
D. Original cost less depreciation
Answer: C
Accountants like to value a derivatives position at the exit price. This is the price
at which the bank could trade out of the position or enter into an offsetting
transaction.
15.In the
A.
B.
C.
D.

U.S., which of the following is true about Treasury instruments


Their income is not subject to tax at the state level
Their income is not subject to tax at the federal level
Both A and B are true
They are not subject to capital gains tax at the federal level

Answer: A
Income from Treasury instruments is not subject to tax at the state level. This is
one of the reasons why the yield on Treasuries is lower than the yield on other
instruments that have very little credit risk.

16.Suppose that OIS rates of all maturities are 6% per annum, continuously
compounded. The one-year LIBOR rate is 6.4%, annually compounded and
the two-year swap rate for a swap where payments are exchanged annually
is 6.8%, annually compounded. Which of the following is closest to the LIBOR
forward rate for the second year when LIBOR discounting is used and the rate
is expressed with annual compounding
A. 7.199%
B. 7.221%
C. 7.223%
D. 7.225%
Answer: C
When LIBOR discounting is used, the OIS rates are irrelevant. The two year
LIBOR/swap zero rate, R, is given by

6.8
106.8

100
1.064 (1 R ) 2
so that R=6.8137%. We can calculate the forward rate from the one- and twoyear zero rates as 1.0681372/1.0641 or 7.223%

17.Suppose that OIS rates of all maturities are 6% per annum, continuously
compounded. The one-year LIBOR rate is 6.4%, annually compounded and
the two-year swap rate for a swap where payments are exchanged annually
is 6.8%, annually compounded. Which of the following is closest to the LIBOR
forward rate for the second year when OIS discounting is used and the rate is
expressed with annual compounding?
A. 7.199%
B. 7.221%
C. 7.223%
D. 7.225%
Answer: D
In the two-year swap the forward rate corresponding to the first exchange is the
one-year zero rate or 6.4%. This means that, when a fixed rate is paid the value
of that exchange per $100 of principal is $100(0.064-0.068)e 0.061 =-$0.3767.
If F is the forward rate for the second year we must have
(F-0.068)e-0.062 =0.3767
so that F=0.07225.
18.Which of the following involves most credit risk
A. Exchange trading
B. OTC trading with a central clearing party being used
C. OTC trading with bilateral clearing and collateral being posted
D. OTC trading with bilateral clearing and no collateral being posted

Answer: D
In the case of both exchange trading and trading using a CCP initial margin and
variation margin have to be posted so that the risk of a loss because of a default
is low. Bilateral clearing usually involves more credit risk than exchange/CCP
trading and credit risk is greater when there is no collateral agreement.
19.A bank has three uncollateralized transactions with a counterparty worth +
$10 million, $20 million and +$25 million. A netting agreement is in place.
What is the maximum loss if the counterparty defaults today.
A. $15 million
B. $35 million
C. $20 million
D. Zero
Answer: A
The netting agreement means that the three transactions are considered to be a
single transaction. The net value of the transactions to the bank is 1020+25 or
$15 million. This is the maximum amount that could be lost if the counterparty
defaults today.
20.Since the 2008 credit crisis
A. LIBOR has replaced OIS
swaps
B. OIS has replaced LIBOR
swaps
C. LIBOR has replaced OIS
D. OIS has replaced LIBOR

as the discount rate for non-collateralized


as the discount rate for non-collateralized
as the discount rate for collateralized swaps
as the discount rate for collateralized swaps

Answer: D
OIS has replaced LIBOR as the discount rate for collateralized derivatives.