CFM Derivatives & Hedging Strategies 3 — Questions and Answers
Question 1: A total return swap allows the protection buyer to:
- Receive fixed coupon payments from the counterparty
- Transfer the credit and market risk of a reference asset to the counterparty (Correct answer)
- Gain leveraged exposure to interest rate movements
- Convert floating-rate income to fixed-rate income
Correct answer: Transfer the credit and market risk of a reference asset to the counterparty
In a total return swap, the buyer pays the total return of a reference asset and receives a floating rate, effectively transferring both credit and market risk.
Question 2: The delta of a deep in-the-money call option approaches:
- 0
- 0.5
- 1 (Correct answer)
- -1
Correct answer: 1
As a call option moves deep in-the-money, it behaves increasingly like the underlying asset itself, so delta approaches 1.
Question 3: Which strategy profits from low volatility and a range-bound underlying asset?
- Long straddle
- Long strangle
- Short iron condor
- Long iron condor (Correct answer)
Correct answer: Long iron condor
A long iron condor involves selling an OTM strangle and buying a wider OTM strangle, profiting when the underlying stays within a defined range.
Question 4: For a bond portfolio manager, duration-based hedging using Treasury futures requires adjusting the number of contracts based on:
- The yield to maturity of the portfolio only
- The dollar duration of the portfolio and the futures contract (Correct answer)
- The convexity of the portfolio divided by the futures price
- The coupon rate differential between the portfolio and CTD bond
Correct answer: The dollar duration of the portfolio and the futures contract
The number of futures contracts needed equals the target dollar duration change divided by the dollar duration of one futures contract.
Question 5: A swaption that gives the holder the right to enter a swap as the fixed-rate payer is called a:
- Receiver swaption
- Payer swaption (Correct answer)
- Callable swap
- Cancellable swap
Correct answer: Payer swaption
A payer swaption grants the right to pay fixed and receive floating, and gains value when interest rates rise.
Question 6: The cost-of-carry model for futures pricing includes all of the following EXCEPT:
- Risk-free rate
- Storage costs
- Convenience yield
- Credit spread of the futures seller (Correct answer)
Correct answer: Credit spread of the futures seller
The cost-of-carry model incorporates risk-free rate, storage costs, and convenience yield; exchange-cleared futures eliminate counterparty credit spread.
Question 7: Which derivative instrument is most appropriate for hedging the risk that a planned future investment will be made at a higher interest rate than current rates?
- An interest rate cap
- A receiver swaption (Correct answer)
- An interest rate floor
- A payer swaption
Correct answer: A receiver swaption
A receiver swaption gives the right to receive fixed rates; if rates fall before the investment, it compensates by locking in the higher fixed rate.
CFM Derivatives & Hedging Strategies 3
A total return swap allows the protection buyer to: