CSC Derivatives and Risk Management 2 — Questions and Answers
Question 1: A Canadian pension fund holds a large equity portfolio and wants to reduce market exposure without selling shares. Which derivative strategy is most appropriate?
- Buy call options on the index
- Sell index futures contracts (Correct answer)
- Buy put options on individual stocks
- Enter a currency swap agreement
Correct answer: Sell index futures contracts
Selling index futures allows the fund to hedge systematic risk while retaining ownership of the underlying shares.
Question 2: What is the primary difference between an American-style option and a European-style option?
- American options trade on exchanges; European options trade OTC
- American options can be exercised any time before expiry; European only at expiry (Correct answer)
- American options have no expiry date
- European options always have higher premiums
Correct answer: American options can be exercised any time before expiry; European only at expiry
American-style options grant the holder the right to exercise at any point up to and including the expiration date.
Question 3: Which of the following best describes 'basis risk' in a futures hedge?
- The risk that the futures exchange defaults on settlement
- The risk that the spot price and futures price do not converge as expected (Correct answer)
- The risk of margin calls exceeding available capital
- The risk of early assignment on a short futures position
Correct answer: The risk that the spot price and futures price do not converge as expected
Basis risk arises when the difference between the spot price and futures price changes in an unexpected way, reducing hedge effectiveness.
Question 4: A trader sells a naked call option. What is the maximum potential loss on this position?
- Limited to the premium received
- The strike price minus the premium
- Unlimited, as the underlying price can rise without bound (Correct answer)
- The notional value of the contract
Correct answer: Unlimited, as the underlying price can rise without bound
A naked (uncovered) short call has theoretically unlimited loss potential because the underlying asset price can rise indefinitely.
Question 5: In the context of swap agreements, what does the 'notional principal' represent?
- The actual amount exchanged between counterparties at inception
- The reference amount used to calculate periodic interest payments (Correct answer)
- The market value of the swap at any given time
- The collateral pledged to secure the swap
Correct answer: The reference amount used to calculate periodic interest payments
Notional principal is not exchanged; it serves as the reference value on which cash flows are calculated.
Question 6: Which Greek measures the rate of change of an option's delta with respect to changes in the underlying asset's price?
- Theta
- Vega
- Gamma (Correct answer)
- Rho
Correct answer: Gamma
Gamma measures how much delta changes for a one-point move in the underlying, reflecting the curvature of the option's value.
Question 7: A Canadian importer expects to pay USD 1 million in 90 days and buys USD/CAD futures to hedge. If the Canadian dollar weakens against the USD, what is the outcome?
- The futures position generates a loss, offsetting the currency gain
- The futures position generates a profit, offsetting the higher CAD cost (Correct answer)
- The hedge is irrelevant because futures are settled in CAD
- The importer faces a margin call regardless of currency movement
Correct answer: The futures position generates a profit, offsetting the higher CAD cost
When CAD weakens, USD becomes more expensive in CAD terms, but the long USD futures position gains value to offset that increased cost.
CSC Derivatives and Risk Management 2
A Canadian pension fund holds a large equity portfolio and wants to reduce market exposure without selling shares.
Which derivative strategy is most appropriate?