CPM Derivatives & Hedging Strategies 2 — Questions and Answers
Question 1: In futures hedging, 'basis risk' refers to the risk that:
- The futures price exceeds the spot price at expiration
- The change in futures price does not perfectly offset the change in spot price (Correct answer)
- The counterparty to a futures transaction defaults
- The futures contract expires before the hedging need is met
Correct answer: The change in futures price does not perfectly offset the change in spot price
Basis risk is the risk that the difference between the spot price and futures price (the 'basis') changes unexpectedly, causing an imperfect hedge.
Question 2: A swap where one party pays a fixed interest rate and receives a floating rate is called a:
- Currency swap
- Total return swap
- Pay-fixed interest rate swap (Correct answer)
- Credit default swap
Correct answer: Pay-fixed interest rate swap
In a pay-fixed interest rate swap, one counterparty pays a fixed rate and receives a floating rate (e.g., SOFR), effectively converting fixed-rate exposure to floating-rate exposure.
Question 3: Credit default swaps (CDS) are primarily used in portfolio management to:
- Increase equity market exposure without buying stocks
- Transfer or hedge credit risk associated with a bond issuer (Correct answer)
- Speculate on interest rate movements
- Convert fixed-rate bonds to floating-rate bonds
Correct answer: Transfer or hedge credit risk associated with a bond issuer
CDS contracts allow portfolio managers to buy or sell protection against the default of a bond issuer, effectively transferring credit risk without selling the underlying bond.
Question 4: A portfolio manager wishes to increase portfolio duration without buying bonds. The most appropriate derivatives strategy is to:
- Sell interest rate futures
- Enter a pay-fixed interest rate swap
- Enter a receive-fixed interest rate swap (Correct answer)
- Buy put options on bond futures
Correct answer: Enter a receive-fixed interest rate swap
A receive-fixed interest rate swap (paying floating, receiving fixed) increases duration because fixed-rate receipts behave like long bond positions, increasing sensitivity to interest rate changes.
Question 5: The Black-Scholes option pricing model is primarily used to:
- Calculate the fair value of futures contracts
- Determine the theoretical fair price of European options (Correct answer)
- Assess credit risk in bond portfolios
- Estimate the expected return of equity portfolios
Correct answer: Determine the theoretical fair price of European options
The Black-Scholes model calculates the theoretical fair value of European-style options based on inputs including stock price, strike price, time to expiration, volatility, and risk-free rate.
Question 6: The maximum loss for the buyer of a put option is:
- Unlimited
- The strike price minus the premium paid
- The premium paid for the option (Correct answer)
- The current market price of the underlying asset
Correct answer: The premium paid for the option
The buyer of a put option can lose at most the premium paid; if the underlying asset's price rises above the strike, the put expires worthless, but the loss is capped at the premium.
Question 7: A call option is considered 'in-the-money' when:
- The underlying asset's price equals the strike price
- The underlying asset's price is below the strike price
- The underlying asset's price exceeds the strike price (Correct answer)
- The option's time value exceeds its intrinsic value
Correct answer: The underlying asset's price exceeds the strike price
A call option is in-the-money when the current price of the underlying asset is greater than the option's strike price, giving it positive intrinsic value.
CPM Derivatives & Hedging Strategies 2
In futures hedging, 'basis risk' refers to the risk that: