FIA Derivatives & Risk Products 4 — Questions and Answers
Question 1: Which risk measure captures the maximum potential loss over a specified time horizon at a given confidence level?
- Expected shortfall
- Value at Risk (VaR) (Correct answer)
- Beta
- Duration
Correct answer: Value at Risk (VaR)
VaR estimates the worst expected loss over a period at a specified confidence level (e.g., 99% confidence, 1-day horizon).
Question 2: A 'knock-in' barrier option becomes active only when:
- The option expires in the money
- The underlying touches a specified barrier price (Correct answer)
- Implied volatility exceeds a threshold
- The holder exercises the option early
Correct answer: The underlying touches a specified barrier price
A knock-in option starts as inactive and only becomes a standard option if the underlying asset price touches the barrier level.
Question 3: In a commodity swap, the 'fixed price payer' benefits when:
- Commodity prices fall below the fixed price
- Commodity prices rise above the fixed price (Correct answer)
- Interest rates rise during the swap term
- The commodity's storage costs increase
Correct answer: Commodity prices rise above the fixed price
The fixed price payer receives the floating (market) price; when spot prices rise above the fixed rate, net receipts are positive.
Question 4: What does 'theta' represent in options pricing?
- Sensitivity of option price to changes in volatility
- Rate of time decay in an option's value (Correct answer)
- Sensitivity of delta to changes in the underlying
- Change in option price for a 1% move in the risk-free rate
Correct answer: Rate of time decay in an option's value
Theta measures how much an option's value decreases each day, all else equal — options lose time value as expiration approaches.
Question 5: Which of the following best describes 'mark-to-market' for a futures position?
- Recording futures at original cost until maturity
- Daily settlement of gains and losses through the margin account (Correct answer)
- Netting offsetting futures positions at year-end
- Pricing futures based on historical average prices
Correct answer: Daily settlement of gains and losses through the margin account
Futures are marked to market daily, with gains credited and losses debited from margin accounts through the clearinghouse.
Question 6: A credit-linked note (CLN) is best described as:
- A pure credit derivative with no funded component
- A funded instrument that embeds a credit default swap (Correct answer)
- An equity derivative linked to a credit index
- A repo agreement collateralized by corporate bonds
Correct answer: A funded instrument that embeds a credit default swap
A CLN is a bond where the issuer's obligation to repay principal is linked to the credit performance of a reference entity, embedding a CDS.
Question 7: What is the primary advantage of exchange-traded derivatives over OTC derivatives?
- Greater customization of contract terms
- Elimination of counterparty risk via central clearing (Correct answer)
- Lower regulatory oversight
- More flexibility in settlement dates
Correct answer: Elimination of counterparty risk via central clearing
Exchange-traded derivatives use a central clearinghouse that becomes the counterparty to both sides, virtually eliminating bilateral credit risk.
FIA Derivatives & Risk Products 4
Which risk measure captures the maximum potential loss over a specified time horizon at a given confidence level?