FIA Derivatives & Risk Products 3 — Questions and Answers
Question 1: What is the primary purpose of a total return swap (TRS)?
- To hedge against interest rate changes only
- To transfer the total economic exposure of an asset without transferring ownership (Correct answer)
- To exchange fixed coupon payments for floating payments
- To speculate on currency movements
Correct answer: To transfer the total economic exposure of an asset without transferring ownership
A TRS transfers both the income and capital gains/losses of a reference asset to the receiver, without the asset changing hands.
Question 2: In an interest rate cap agreement, the cap seller must pay when:
- The reference rate falls below the cap rate
- The reference rate exceeds the cap rate (Correct answer)
- The notional principal is fully amortized
- The buyer exercises an early termination right
Correct answer: The reference rate exceeds the cap rate
The cap seller pays the difference when the floating reference rate rises above the agreed cap rate on each reset date.
Question 3: Which risk arises when the maturity of a futures hedge does not perfectly match the maturity of the exposure being hedged?
- Basis risk (Correct answer)
- Liquidity risk
- Counterparty risk
- Regulatory risk
Correct answer: Basis risk
Basis risk occurs because the futures price and spot price may not move in perfect lockstep, especially when maturities differ.
Question 4: A protective put strategy is best described as:
- Selling a put to generate income on a long stock position
- Buying a put to limit downside on an existing long stock position (Correct answer)
- Buying a call to profit from an anticipated price increase
- Selling a call against a long stock to reduce cost basis
Correct answer: Buying a put to limit downside on an existing long stock position
A protective put combines long stock with a long put, effectively creating a floor below which losses are capped.
Question 5: What is 'contango' in futures markets?
- When spot prices are higher than futures prices
- When futures prices are higher than spot prices (Correct answer)
- When futures prices are equal to expected spot prices
- When futures prices decline as expiration approaches
Correct answer: When futures prices are higher than spot prices
Contango describes when futures prices exceed current spot prices, typically due to storage costs and carrying charges.
Question 6: The delta of a deeply in-the-money call option approaches:
- 0
- 0.5
- 1.0 (Correct answer)
- -1.0
Correct answer: 1.0
A deep in-the-money call behaves almost like the underlying asset itself, so its delta approaches 1.0.
Question 7: Which type of credit derivative allows the protection buyer to receive par value in exchange for delivering a defaulted bond to the protection seller?
- Cash-settled CDS
- Physically settled CDS (Correct answer)
- Total return swap
- Credit-linked note
Correct answer: Physically settled CDS
In a physically settled CDS, upon a credit event the buyer delivers the defaulted obligation and receives the full notional (par) amount.
FIA Derivatives & Risk Products 3
What is the primary purpose of a total return swap (TRS)?