CFA Derivatives and Risk Management 2 — Questions and Answers
Question 1: Value at Risk (VaR) at a 95% confidence level and a 1-day horizon means:
- The portfolio will lose more than the VaR amount 5 days out of every 100 (Correct answer)
- The portfolio will never lose more than the VaR amount
- The expected loss over one day is exactly equal to VaR
- VaR equals 95% of the maximum possible daily loss
Correct answer: The portfolio will lose more than the VaR amount 5 days out of every 100
95% VaR means there is a 5% probability of losing more than the VaR amount over the specified horizon; losses exceeding VaR are expected 5 out of every 100 days.
Question 2: Conditional VaR (CVaR), also called Expected Shortfall, improves on VaR because it measures:
- The maximum possible loss with certainty
- The expected loss given that the loss exceeds the VaR threshold (Correct answer)
- The loss at exactly the VaR confidence level
- The loss from systematic risk only
Correct answer: The expected loss given that the loss exceeds the VaR threshold
CVaR is the average loss in the tail beyond the VaR threshold, capturing tail risk that VaR ignores by only identifying the threshold but not the severity of losses beyond it.
Question 3: Which of the following best describes a credit default swap (CDS)?
- An exchange-traded contract to buy or sell bonds at a fixed price
- A derivative where the protection buyer pays periodic premiums in exchange for a payment if a credit event occurs (Correct answer)
- A structured product that tranches credit risk into senior and junior claims
- A forward contract to exchange floating for fixed interest payments
Correct answer: A derivative where the protection buyer pays periodic premiums in exchange for a payment if a credit event occurs
In a CDS, the protection buyer pays periodic premiums to the protection seller, who makes a payment if the reference entity experiences a credit event (e.g., default).
Question 4: Gamma (Γ) of an option is highest when:
- The option is deep in-the-money with a long time to expiry
- The option is near-the-money and close to expiration (Correct answer)
- The option is deep out-of-the-money with volatility rising
- The underlying asset pays a high dividend yield
Correct answer: The option is near-the-money and close to expiration
Gamma is largest for at-the-money options near expiration because delta is changing most rapidly as the option transitions between in- and out-of-the-money.
Question 5: Which risk management strategy is MOST appropriate when a firm wants to eliminate the risk of an adverse price move but retain the potential to benefit from a favorable move?
- Short a futures contract on the exposure
- Enter a forward contract to lock in a fixed price
- Buy an option to hedge the downside while retaining upside (Correct answer)
- Sell an option to collect premium and offset losses
Correct answer: Buy an option to hedge the downside while retaining upside
Buying options provides asymmetric protection: you pay a premium to eliminate downside risk while retaining full upside participation if prices move favorably.
Question 6: A firm has a floating-rate loan and is concerned rates will rise. To manage this risk, the firm should:
- Enter a receive-fixed, pay-floating interest rate swap
- Enter a pay-fixed, receive-floating interest rate swap
- Buy a cap on interest rates
- Both B and C are appropriate strategies (Correct answer)
Correct answer: Both B and C are appropriate strategies
Both paying fixed/receiving floating in a swap and buying an interest rate cap limit the firm's exposure to rising rates; either strategy is appropriate depending on cost and flexibility needs.
CFA Derivatives and Risk Management 2
Value at Risk (VaR) at a 95% confidence level and a 1-day horizon means: