FIA Derivatives & Risk Products 5 — Questions and Answers
Question 1: An investor sells a covered call. The maximum profit from this strategy is:
- Unlimited, as the stock can rise indefinitely
- The premium received plus any stock appreciation up to the strike price (Correct answer)
- The premium received minus the stock's current price
- Equal to the intrinsic value of the call at expiration
Correct answer: The premium received plus any stock appreciation up to the strike price
The covered call caps upside at the strike price; max profit = call premium received + (strike price − purchase price of stock).
Question 2: Which swap structure is most commonly used by a corporation to convert floating-rate debt into fixed-rate debt?
- Equity swap
- Plain vanilla interest rate swap (pay fixed, receive floating) (Correct answer)
- Cross-currency swap
- Credit default swap
Correct answer: Plain vanilla interest rate swap (pay fixed, receive floating)
A pay-fixed, receive-floating interest rate swap offsets the floating payments on existing debt, effectively converting it to fixed-rate.
Question 3: The 'rho' of an option measures its sensitivity to changes in:
- The underlying asset's price
- Implied volatility
- The risk-free interest rate (Correct answer)
- Time remaining to expiration
Correct answer: The risk-free interest rate
Rho quantifies how much an option's price changes for a 1% change in the risk-free interest rate.
Question 4: Which of the following correctly describes 'backwardation' in a commodity futures market?
- Futures prices are higher than current spot prices
- The futures curve is upward-sloping over time
- Spot prices exceed futures prices (Correct answer)
- Storage costs exceed the convenience yield
Correct answer: Spot prices exceed futures prices
Backwardation occurs when the spot price is above the futures price, often signaling tight near-term supply or high convenience yield.
Question 5: Under the put-call parity relationship, buying a call and selling a put at the same strike and expiry is equivalent to:
- Buying the underlying asset on a leveraged basis
- A long forward position on the underlying asset (Correct answer)
- A short position in a risk-free bond
- Selling the underlying asset short
Correct answer: A long forward position on the underlying asset
Put-call parity shows that a long call plus a short put at the same strike/expiry replicates a long forward contract on the underlying.
Question 6: What is the main function of an initial margin requirement in derivatives trading?
- To compensate the broker for administrative costs
- To serve as a good-faith deposit covering potential future losses (Correct answer)
- To pay the counterparty's transaction fees upfront
- To fund the daily mark-to-market settlements immediately
Correct answer: To serve as a good-faith deposit covering potential future losses
Initial margin is collateral posted at trade inception to cover potential adverse price moves before the next daily settlement.
Question 7: A forward rate agreement (FRA) is used primarily to:
- Lock in an exchange rate for a future currency transaction
- Hedge or speculate on a future short-term interest rate (Correct answer)
- Swap fixed-rate payments for equity index returns
- Transfer credit default risk to a third party
Correct answer: Hedge or speculate on a future short-term interest rate
An FRA allows a party to lock in a borrowing or lending rate for a future period, settling the difference versus the market rate at expiration.
FIA Derivatives & Risk Products 5
An investor sells a covered call.
The maximum profit from this strategy is: