CFM Derivatives & Hedging Strategies 2 — Questions and Answers
Question 1: A fund manager holds a long equity portfolio and buys put options to hedge downside risk. This strategy is best described as:
- A protective put (Correct answer)
- A covered call
- A collar strategy
- A synthetic long
Correct answer: A protective put
Buying put options on an existing long position creates a protective put, limiting downside while preserving upside.
Question 2: Which Greek measures the rate of change of an option's delta with respect to the underlying asset price?
- Vega
- Theta
- Gamma (Correct answer)
- Rho
Correct answer: Gamma
Gamma measures the convexity of the option's value, i.e., how fast delta changes as the underlying price moves.
Question 3: A basis swap involves the exchange of:
- Fixed rate payments for floating rate payments
- Two different floating rate payments (Correct answer)
- Currency cash flows at a fixed exchange rate
- Equity returns for bond coupons
Correct answer: Two different floating rate payments
A basis swap exchanges two floating-rate cash flows tied to different reference rates, such as SOFR vs. T-bill rate.
Question 4: When a futures contract is in backwardation, the futures price is:
- Equal to the expected spot price
- Higher than the current spot price
- Lower than the current spot price (Correct answer)
- Independent of the spot price
Correct answer: Lower than the current spot price
Backwardation occurs when futures prices are below the current spot price, often due to high convenience yields or supply shortages.
Question 5: A fund uses a cross-hedge to manage currency exposure on a position in Danish Krone (DKK) using Euro (EUR) futures. The main risk of this approach is:
- Margin calls on the futures position
- Basis risk between DKK and EUR (Correct answer)
- Lack of liquidity in EUR futures
- Counterparty default on the futures exchange
Correct answer: Basis risk between DKK and EUR
Cross-hedging introduces basis risk because DKK and EUR, while correlated, do not move in perfect lockstep.
Question 6: An interest rate cap is equivalent to a portfolio of:
- Interest rate floors
- Bond futures
- Interest rate call options (caplets) (Correct answer)
- Interest rate put options (floorlets)
Correct answer: Interest rate call options (caplets)
An interest rate cap is composed of a series of individual caplets, each being a call option on a future interest rate fixing.
Question 7: The minimum variance hedge ratio is calculated as the ratio of:
- The futures price to the spot price
- The standard deviation of the spot to the standard deviation of the futures
- The covariance of spot and futures changes to the variance of futures changes (Correct answer)
- The notional of the hedge to the portfolio value
Correct answer: The covariance of spot and futures changes to the variance of futures changes
The optimal hedge ratio equals Cov(ΔS, ΔF) / Var(ΔF), minimizing the variance of the hedged position.
CFM Derivatives & Hedging Strategies 2
A fund manager holds a long equity portfolio and buys put options to hedge downside risk.
This strategy is best described as: