CSC Derivatives and Risk Management 3 — Questions and Answers
Question 1: What is 'delta hedging' in options trading?
- Holding options until expiry to maximize time value
- Continuously adjusting a position in the underlying to maintain a delta-neutral portfolio (Correct answer)
- Selling options with the same strike but different expiries
- Matching the notional value of options to the portfolio size
Correct answer: Continuously adjusting a position in the underlying to maintain a delta-neutral portfolio
Delta hedging involves rebalancing the hedge ratio as delta changes so that the net position has zero directional exposure to small price moves.
Question 2: A protective put strategy involves:
- Buying a put option on a stock you are short
- Buying a put option on a stock you already own long (Correct answer)
- Selling a put option against a short stock position
- Writing a covered put to generate premium income
Correct answer: Buying a put option on a stock you already own long
A protective put pairs a long stock position with a long put, creating a floor on potential losses while preserving upside.
Question 3: Which risk is specifically associated with over-the-counter (OTC) derivatives but not exchange-traded derivatives?
- Market risk
- Liquidity risk
- Counterparty credit risk (Correct answer)
- Interest rate risk
Correct answer: Counterparty credit risk
OTC derivatives lack central clearing, so each party bears the risk that the other party may default on its obligations.
Question 4: An interest rate cap protects a borrower with floating-rate debt because it:
- Locks in a fixed rate regardless of market movements
- Pays the borrower when the reference rate exceeds the cap rate (Correct answer)
- Requires the borrower to pay if rates fall below the cap
- Converts variable-rate debt to fixed-rate debt permanently
Correct answer: Pays the borrower when the reference rate exceeds the cap rate
An interest rate cap compensates the holder when market rates rise above the agreed cap rate, limiting the effective borrowing cost.
Question 5: What does 'open interest' represent in futures markets?
- The total volume of contracts traded during a session
- The number of outstanding contracts not yet settled or closed (Correct answer)
- The difference between the highest and lowest prices during a session
- The daily settlement price set by the exchange
Correct answer: The number of outstanding contracts not yet settled or closed
Open interest counts all futures contracts that remain open (not offset or delivered), reflecting the total market commitment.
Question 6: A bull call spread involves buying a call at a lower strike and selling a call at a higher strike. What is the maximum profit?
- Unlimited upside above the higher strike price
- The difference between the two strike prices minus the net premium paid (Correct answer)
- The net premium received from selling the higher strike call
- The lower strike price minus the net premium paid
Correct answer: The difference between the two strike prices minus the net premium paid
Maximum profit is capped at the spread width (difference in strikes) minus the net premium paid, achieved when the underlying is at or above the higher strike at expiry.
Question 7: In a plain vanilla interest rate swap, which party benefits when floating rates rise significantly above the fixed rate?
- The fixed-rate payer (floating-rate receiver) (Correct answer)
- The floating-rate payer (fixed-rate receiver)
- Both parties benefit equally
- Neither party benefits; gains and losses offset exactly
Correct answer: The fixed-rate payer (floating-rate receiver)
The fixed-rate payer receives the higher floating payments, resulting in a net gain when floating rates exceed the fixed rate.
CSC Derivatives and Risk Management 3
What is 'delta hedging' in options trading?