CPFM - Certified Professional in Financial Management Options, Futures, and Derivatives Questions and Answers 1 — Questions and Answers
Question 1: A U.S. manufacturing company needs to purchase a large quantity of aluminum in three months. The financial manager is concerned that the price of aluminum will increase significantly before the purchase date. Which of the following derivative strategies would be most effective in hedging this price risk?
- Selling aluminum futures contracts.
- Buying aluminum put options.
- Buying aluminum call options or long futures. (Correct answer)
- Entering into a currency swap.
Correct answer: Buying aluminum call options or long futures.
To hedge against a price increase (the risk of paying more in the future), the manager needs a strategy that profits when the price of aluminum goes up. Buying a call option gives the right to buy aluminum at a predetermined price, capping the purchase cost. Going long (buying) a futures contract locks in a purchase price for a future date. Selling futures or buying puts would be used to hedge against a price decrease.
Question 2: Which of the following is a key difference between a futures contract and a forward contract?
- Futures contracts are customized agreements, while forward contracts are standardized.
- Futures contracts are traded on an organized exchange and are marked-to-market daily. (Correct answer)
- Forward contracts have less counterparty risk due to being private agreements.
- Only forward contracts can be used for hedging commodity price risk.
Correct answer: Futures contracts are traded on an organized exchange and are marked-to-market daily.
Futures contracts are standardized and traded on exchanges, with a clearinghouse mitigating counterparty risk. A crucial feature is the daily 'marking-to-market' process, where gains and losses are settled each day. In contrast, forward contracts are customized, private (OTC) agreements with settlement typically occurring only at the end of the contract, which introduces greater counterparty risk.
Question 3: A financial manager is evaluating a call option on a stock with a strike price of $70. If the current market price of the underlying stock is $78, which of the following statements is correct?
- The option has an intrinsic value of $8. (Correct answer)
- The option is considered 'at-the-money'.
- The option has zero time value.
- The holder of the option is obligated to purchase the stock.
Correct answer: The option has an intrinsic value of $8.
The intrinsic value of a call option is the amount by which it is 'in-the-money'. It is calculated as the current stock price minus the strike price. In this case, $78 (stock price) - $70 (strike price) = $8. The option is 'in-the-money', not 'at-the-money'. An option almost always has time value before expiration, and an option provides the right, not the obligation, to buy.
Question 4: A U.S.-based corporation has sold goods to a customer in Germany and is scheduled to receive a payment of €5 million in 90 days. The corporate treasurer is concerned about the risk of the Euro (EUR) depreciating against the U.S. Dollar (USD). Which derivative strategy would effectively hedge this risk?
- Buy EUR call options.
- Go long on EUR futures contracts.
- Purchase a Certificate of Deposit denominated in USD.
- Sell EUR forward or futures contracts. (Correct answer)
Correct answer: Sell EUR forward or futures contracts.
The company's risk is that the €5 million will be worth fewer USD in 90 days. To hedge this, the company needs to lock in an exchange rate at which it can sell its euros for dollars in the future. Selling a EUR forward or futures contract achieves this by creating an obligation to sell euros at a predetermined price, thus neutralizing the risk of the euro's value falling.
Question 5: A corporation has a significant amount of variable-rate debt and the financial manager is concerned that rising interest rates will increase the company's borrowing costs. What is the primary purpose of using an interest rate swap in this scenario?
- To speculate on the future price of a physical commodity.
- To exchange its floating-rate payments for fixed-rate payments. (Correct answer)
- To guarantee the delivery of a foreign currency at a future date.
- To eliminate the need to make any interest payments on its debt.
Correct answer: To exchange its floating-rate payments for fixed-rate payments.
An interest rate swap is an agreement where two parties exchange interest payment streams. For a company with floating-rate debt concerned about rising rates, the most common strategy is a 'plain vanilla' swap where it agrees to pay a fixed rate to a counterparty in exchange for receiving a floating-rate payment. This converts the variable-rate debt into a synthetic fixed-rate obligation, providing certainty over future interest costs.
Question 6: From a risk management perspective, which of the following derivative positions exposes an investor to the highest potential for loss?
- Buying a put option.
- Buying a call option.
- Writing (selling) a naked call option. (Correct answer)
- Writing (selling) a covered call option.
Correct answer: Writing (selling) a naked call option.
Writing (selling) a naked call option involves selling the right to buy a stock that the writer does not own. If the stock price rises significantly, the writer is obligated to buy the stock at the high market price to sell it at the lower strike price. Since there is no theoretical limit to how high a stock price can rise, the potential loss is unlimited. The loss on buying an option is limited to the premium paid, and the risk of a covered call is mitigated by owning the underlying shares.
CPFM - Certified Professional in Financial Management Options, Futures, and Derivatives Questions and Answers 1
A U.S. manufacturing company needs to purchase a large quantity of aluminum in three months.
The financial manager is concerned that the price of aluminum will increase significantly before the purchase date.
Which of the following derivative strategies would be most effective in hedging this price risk?