CTP Financial Risk Management 3 — Questions and Answers
Question 1: Conditional Value at Risk (CVaR), also called Expected Shortfall, improves upon standard VaR because it:
- Uses fewer assumptions about return distributions
- Measures the average loss in the tail beyond the VaR threshold (Correct answer)
- Is always a lower number than VaR
- Eliminates model risk entirely
Correct answer: Measures the average loss in the tail beyond the VaR threshold
CVaR captures the expected magnitude of losses that exceed the VaR threshold, providing a fuller picture of tail risk.
Question 2: A company with significant commodity price exposure decides to use a 'stack-and-roll' hedging strategy. What is the primary risk of this approach?
- Counterparty default on all contracts simultaneously
- Rolling losses if the futures curve is in contango (Correct answer)
- The inability to find liquid contracts
- Hedge accounting disqualification under ASC 815
Correct answer: Rolling losses if the futures curve is in contango
In a contango market, rolling short-dated contracts forward is done at progressively higher prices, creating roll costs that erode hedge effectiveness.
Question 3: Which metric measures how much a bond's price will change for a 1 basis point move in yield, and is commonly used to size interest rate hedges?
- Convexity
- Dollar Value of a Basis Point (DV01) (Correct answer)
- Modified duration
- Macaulay duration
Correct answer: Dollar Value of a Basis Point (DV01)
DV01 (also called PV01 or PVBP) expresses the dollar change in a bond's price for a 1 basis point change in yield and is the standard tool for sizing rate hedges.
Question 4: A treasurer observes that the company's FX forwards are creating large balance sheet items as rates move. The most effective way to reduce this accounting volatility without eliminating the economic hedge is to:
- Terminate all forward contracts immediately
- Elect cash flow hedge accounting and defer fair value changes in OCI (Correct answer)
- Switch all forwards to options
- Reduce the notional amount of forwards by 50%
Correct answer: Elect cash flow hedge accounting and defer fair value changes in OCI
Designating qualifying forwards as cash flow hedges allows the effective portion of mark-to-market changes to flow through OCI rather than earnings, reducing income statement volatility.
Question 5: Liquidity risk in a derivatives portfolio is most likely to become acute when:
- Interest rates fall sharply and a pay-fixed swap is out of the money (Correct answer)
- Credit spreads tighten and the portfolio's fair value increases
- The hedged item matures before the derivative
- The company upgrades its credit rating
Correct answer: Interest rates fall sharply and a pay-fixed swap is out of the money
When a pay-fixed swap moves against the company (rates fall), margin or collateral calls can create sudden cash outflows, straining liquidity.
Question 6: When a central clearing counterparty (CCP) is used for OTC derivatives, initial margin is designed to cover:
- Potential future exposure over the close-out period (Correct answer)
- Only the current mark-to-market loss
- The present value of all remaining cash flows
- Historical average losses over one year
Correct answer: Potential future exposure over the close-out period
Initial margin posted at a CCP is sized to cover potential future exposure during the period it would take to close out or replace the position if a member defaults.
Question 7: A corporate treasurer wants to protect against rising rates on anticipated debt issuance six months from now. The most direct hedge is to:
- Buy Treasury bond futures
- Sell Treasury bond futures (Correct answer)
- Buy a receive-fixed interest rate swap
- Enter a forward rate agreement to receive fixed
Correct answer: Sell Treasury bond futures
Selling Treasury bond futures profits when rates rise (bond prices fall), offsetting the higher borrowing cost the company will face at issuance.
CTP Financial Risk Management 3
Conditional Value at Risk (CVaR), also called Expected Shortfall, improves upon standard VaR because it: