CSC Derivatives and Risk Management 5 — Questions and Answers
Question 1: Which of the following is a key advantage of exchange-traded options over OTC options?
- Greater customization of contract terms
- Elimination of counterparty credit risk through central clearing (Correct answer)
- Higher leverage ratios available to retail investors
- No margin requirements for either buyer or seller
Correct answer: Elimination of counterparty credit risk through central clearing
Exchange-traded options are cleared through a central clearinghouse, which guarantees performance and eliminates bilateral counterparty credit risk.
Question 2: A company with floating-rate debt enters a pay-fixed, receive-floating interest rate swap. What effective rate does the company pay?
- Only the floating market rate on its debt
- Only the fixed rate on the swap, with floating payments netting to zero
- A synthetic fixed rate combining its floating debt payments and the swap's net settlement (Correct answer)
- Zero, because the swap payments offset the debt payments entirely
Correct answer: A synthetic fixed rate combining its floating debt payments and the swap's net settlement
The company pays floating on its debt and receives floating from the swap (which nets to approximately zero), leaving only the fixed swap payment — creating a synthetic fixed rate.
Question 3: What is the 'time value' of an option?
- The intrinsic value of the option if exercised immediately
- The portion of the option premium above intrinsic value, reflecting remaining time to expiry (Correct answer)
- The interest forgone by paying the option premium upfront
- The value of the option when it is deep in-the-money
Correct answer: The portion of the option premium above intrinsic value, reflecting remaining time to expiry
Time value represents the extra amount buyers pay beyond intrinsic value for the possibility that favorable price movements will occur before expiry.
Question 4: What does a high positive gamma indicate about an options position?
- The position profits only if the underlying remains stable
- The delta of the position will change rapidly with small moves in the underlying (Correct answer)
- The position has significant time decay working against it
- The position has minimal sensitivity to volatility changes
Correct answer: The delta of the position will change rapidly with small moves in the underlying
High gamma means delta changes quickly with price movements, requiring frequent rebalancing for delta-neutral strategies and indicating sensitivity to price direction.
Question 5: Under the CSC framework, which of the following is a characteristic of a forward rate agreement (FRA)?
- It is exchange-traded and requires daily margin settlement
- It is an OTC contract fixing an interest rate for a future period (Correct answer)
- It obligates the buyer to purchase a fixed-income security at a future date
- It gives the holder the right but not the obligation to borrow at a fixed rate
Correct answer: It is an OTC contract fixing an interest rate for a future period
An FRA is a bilateral OTC contract in which two parties agree on an interest rate to be applied to a notional amount for a specified future period.
Question 6: Which scenario would result in a loss for the buyer of a put option at expiry?
- The underlying price falls below the strike price by more than the premium paid
- The underlying price rises above the strike price (Correct answer)
- The underlying price equals the strike price exactly
- The underlying price falls to zero
Correct answer: The underlying price rises above the strike price
A put buyer profits when the underlying falls below the strike; if the underlying price is above the strike at expiry, the put expires worthless and the buyer loses the full premium.
Question 7: Which of the following best describes 'delta' for a long call option as it moves deep in-the-money?
- Delta approaches 0, as the option's intrinsic value dominates
- Delta approaches +1, meaning the option moves almost dollar-for-dollar with the underlying (Correct answer)
- Delta approaches -1, reflecting the increasing cost of the option
- Delta remains constant at 0.5 regardless of moneyness
Correct answer: Delta approaches +1, meaning the option moves almost dollar-for-dollar with the underlying
As a call option moves deep in-the-money, its delta approaches +1 because the option behaves increasingly like owning the underlying asset outright.
CSC Derivatives and Risk Management 5
Which of the following is a key advantage of exchange-traded options over OTC options?