Derivatives and Risk Hedging Flashcards

What is the primary purpose of using derivatives for hedging?

Answer: To reduce or offset financial risk

Derivatives are used in hedging to offset potential losses in an underlying position by taking an opposite position in a related instrument.

A company expecting to receive €5 million in 3 months wants to eliminate currency risk. Which derivative is most appropriate?

Answer: Forward contract

A forward contract locks in the exchange rate for a future date, eliminating currency risk entirely by fixing the conversion terms today.

The 'delta' of an option represents:

Answer: The sensitivity of option price to changes in the underlying asset price

Delta measures how much an option's price changes for a $1 change in the price of the underlying asset, ranging from 0 to 1 for calls and -1 to 0 for puts.

A long position in a crude oil futures contract is best described as:

Answer: An obligation to buy crude oil at a specified price and date

A long futures position obligates the holder to buy the underlying asset at the agreed-upon price on the delivery date, unlike options which confer a right.

Which of the following best describes a perfect hedge?

Answer: A hedge that eliminates all potential gains and losses from the hedged position

A perfect hedge fully offsets the risk of the underlying position, eliminating both potential gains and losses, resulting in a locked-in outcome.

An airline buys call options on jet fuel to hedge against rising fuel costs. This strategy is classified as:

Answer: Long hedge

A long hedge involves buying futures or call options to protect against rising prices in a commodity the hedger expects to purchase in the future.

Basis risk in a futures hedge arises from:

Answer: The spot price and futures price not converging perfectly at delivery

Basis risk occurs because the spot price and futures price may not move in perfect correlation, meaning the hedge may not perfectly offset the underlying exposure.

A company with floating-rate debt enters a pay-fixed, receive-floating interest rate swap. This hedge protects against:

Answer: Rising interest rates

Paying fixed and receiving floating means the company's net cost is fixed; when rates rise, the higher floating receipts offset increased floating debt costs.

Which Greek letter measures the rate of change of delta with respect to the underlying asset price?

Answer: Gamma

Gamma measures how quickly delta changes as the underlying price moves, indicating the convexity of the option's value and the difficulty of maintaining a delta-neutral hedge.

A portfolio manager holds a large equity portfolio and wants to reduce market exposure without selling shares. The most efficient strategy is to:

Answer: Sell equity index futures contracts

Selling equity index futures creates a short position that offsets losses in the long equity portfolio when markets decline, reducing net market exposure.

The optimal hedge ratio in a futures hedge is calculated as:

Answer: The correlation between spot and futures returns multiplied by the ratio of their standard deviations

The optimal hedge ratio h* = ρ × (σS / σF), where ρ is the correlation and σS/σF is the ratio of standard deviations of spot and futures returns.

A cross-currency swap differs from a plain vanilla interest rate swap primarily because it:

Answer: Involves exchange of principal amounts in two different currencies

Cross-currency swaps involve exchanging principal and interest payments in two different currencies, unlike interest rate swaps which involve a single currency.

'Vega' in options pricing measures the sensitivity of option price to changes in:

Answer: The implied volatility of the underlying

Vega measures how much an option's value changes for a 1% change in the implied volatility of the underlying asset; all options have positive vega.

A 'protective put' strategy involves:

Answer: Buying put options on a stock you already own to limit downside losses

A protective put involves buying a put option on a long stock position to insure against downside price movements, effectively setting a floor on losses.

The 'theta' of a long option position is typically negative because:

Answer: Options lose extrinsic value as expiration approaches due to time decay

Theta is negative for long options because time decay continuously erodes the option's time value, even if the underlying price remains unchanged.

Which type of risk does a credit default swap (CDS) primarily transfer from buyer to seller?

Answer: Credit risk

A CDS transfers credit risk: the protection buyer pays a periodic premium, and the protection seller compensates the buyer if the reference entity defaults.

After entering a pay-fixed, receive-floating swap on top of floating-rate debt, a company's combined debt is effectively:

Answer: Fixed rate

The floating payment received from the swap offsets the floating payment owed on the debt, leaving only the fixed payment due on the swap — converting the exposure to fixed rate.

In the context of derivatives, 'delta hedging' refers to:

Answer: Continuously adjusting positions to maintain a delta-neutral portfolio

Delta hedging involves dynamically rebalancing the hedge position to keep the overall delta near zero, making the portfolio insensitive to small movements in the underlying.

An airline enters a long oil futures contract to hedge fuel costs. Oil prices then fall significantly. The outcome is:

Answer: The futures position generates a loss that offsets the benefit of lower fuel costs

The long futures position loses value when oil prices fall, offsetting the gain from buying cheaper fuel in the spot market — illustrating that a perfect hedge eliminates both upside and downside.

Which of the following accurately describes a 'collar' options strategy?

Answer: Owning the underlying, buying a protective put, and selling a covered call

A collar combines a long underlying position with a protective put (floor on losses) and a short call (cap on gains), typically at low or zero net cost.