CFA Derivatives and Risk Management 3 β Questions and Answers
Question 1: Vega (Ξ½) measures an option's sensitivity to changes in:
- The underlying asset's price
- The risk-free interest rate
- The time remaining to expiration
- Implied volatility of the underlying asset (Correct answer)
Correct answer: Implied volatility of the underlying asset
Vega measures how much the option's price changes for a 1% change in implied volatility; options increase in value with higher volatility (for both calls and puts).
Question 2: Which of the following is an example of basis risk in a hedging strategy?
- A mismatch between the hedge's notional amount and the portfolio's value
- Using a futures contract whose underlying does not perfectly match the asset being hedged, causing imperfect hedge performance (Correct answer)
- The risk that the counterparty to a hedge defaults
- The risk that regulatory changes make the hedge illegal
Correct answer: Using a futures contract whose underlying does not perfectly match the asset being hedged, causing imperfect hedge performance
Basis risk arises when the futures contract's underlying (or its price behavior) does not perfectly match the hedged asset, causing the hedge to be imperfect.
Question 3: A bull call spread is constructed by:
- Buying a call at a lower strike and selling a call at a higher strike (Correct answer)
- Buying a call and selling a put at the same strike
- Buying two calls at different strikes and selling the underlying
- Selling a call at a lower strike and buying a call at a higher strike
Correct answer: Buying a call at a lower strike and selling a call at a higher strike
A bull call spread = long call at lower strike + short call at higher strike; it profits from moderate upward price moves while capping both profit and loss.
Question 4: In the Black-Scholes-Merton model, an increase in which of the following inputs increases call option value?
- Increase in the strike price
- Increase in time to expiration (Correct answer)
- Decrease in underlying stock price
- Decrease in risk-free rate
Correct answer: Increase in time to expiration
More time to expiration increases option value because there is more opportunity for the underlying to move favorably; time decay (theta) erodes value as expiry approaches.
Question 5: Which of the following is NOT a characteristic of exchange-traded derivatives?
- Standardized contract terms
- Centralized clearing through a clearinghouse
- Fully customizable terms to meet counterparty needs (Correct answer)
- Daily mark-to-market with margin calls
Correct answer: Fully customizable terms to meet counterparty needs
Exchange-traded derivatives have standardized, non-customizable terms; customization is the hallmark of OTC derivatives, which sacrifice standardization for flexibility.
Question 6: Enterprise Risk Management (ERM) differs from traditional risk management by:
- Focusing only on financial market risks such as interest rate and credit risk
- Integrating all categories of risk (financial, operational, strategic, reputational) into a unified firm-wide framework (Correct answer)
- Delegating risk management to individual business units independently
- Prioritizing compliance risk above all other risk categories
Correct answer: Integrating all categories of risk (financial, operational, strategic, reputational) into a unified firm-wide framework
ERM takes a holistic, firm-wide approach by integrating all risk types into a single coordinated framework, rather than managing each risk category in silos.
CFA Derivatives and Risk Management 3
Vega (Ξ½) measures an option's sensitivity to changes in: