Financial Risk Management Derivatives and Risk Hedging — Questions and Answers

Question 1: What is the primary purpose of using derivatives for hedging?

To speculate on price movements
To reduce or offset financial risk (Correct answer)
To increase leverage in a portfolio
To generate arbitrage profits

Correct 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.

Question 2: A company expecting to receive €5 million in 3 months wants to eliminate currency risk. Which derivative is most appropriate?

Currency call option
Forward contract (Correct answer)
Interest rate swap
Credit default swap

Correct 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.

Question 3: The 'delta' of an option represents:

The option's time value decay per day
The sensitivity of option price to changes in the underlying asset price (Correct answer)
The probability that the option expires worthless
The volatility of the underlying asset

Correct 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.

Question 4: A long position in a crude oil futures contract is best described as:

An obligation to sell crude oil at a specified price and date
An obligation to buy crude oil at a specified price and date (Correct answer)
The right to buy crude oil at a specified price
The right to sell crude oil at a specified price

Correct 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.

Question 5: Which of the following best describes a perfect hedge?

A hedge that eliminates all potential gains and losses from the hedged position (Correct answer)
A hedge that maximizes profit while minimizing risk
A hedge that reduces risk by exactly 50%
A hedge that only protects against downside risk

Correct 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.

Question 6: An airline buys call options on jet fuel to hedge against rising fuel costs. This strategy is classified as:

Speculative hedging
Static delta hedge
Long hedge (Correct answer)
Short hedge

Correct 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.

Question 7: Basis risk in a futures hedge arises from:

The spot price and futures price not converging perfectly at delivery (Correct answer)
The credit risk of the futures clearinghouse defaulting
The inability to find a willing counterparty in the market
Regulatory restrictions on futures position sizes

Correct 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.

Question 8: A company with floating-rate debt enters a pay-fixed, receive-floating interest rate swap. This hedge protects against:

Rising interest rates (Correct answer)
Falling interest rates
Credit spread widening
Currency depreciation

Correct 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.

Question 9: Which Greek letter measures the rate of change of delta with respect to the underlying asset price?

Vega
Theta
Gamma (Correct answer)
Rho

Correct 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.

Question 10: A portfolio manager holds a large equity portfolio and wants to reduce market exposure without selling shares. The most efficient strategy is to:

Buy equity index futures contracts
Sell equity index futures contracts (Correct answer)
Buy deep in-the-money call options
Enter a pay-fixed interest rate swap

Correct 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.

Question 11: The optimal hedge ratio in a futures hedge is calculated as:

The ratio of spot price to futures price
The correlation between spot and futures returns multiplied by the ratio of their standard deviations (Correct answer)
The portfolio beta divided by the futures contract size
The number of futures contracts divided by the portfolio value

Correct 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.

Question 12: A cross-currency swap differs from a plain vanilla interest rate swap primarily because it:

Involves exchange of principal amounts in two different currencies (Correct answer)
Involves only fixed-to-fixed interest rate payments
Does not require any periodic coupon payments
Is only available for maturities under one year

Correct 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.

Question 13: 'Vega' in options pricing measures the sensitivity of option price to changes in:

The passage of time to expiration
The risk-free interest rate
The implied volatility of the underlying (Correct answer)
The price of the underlying asset

Correct 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.

Question 14: A 'protective put' strategy involves:

Selling put options against a short stock position to generate income
Buying put options on a stock you already own to limit downside losses (Correct answer)
Buying call options as protection against missing upside
Selling covered calls to generate premium income

Correct 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.

Question 15: The 'theta' of a long option position is typically negative because:

Options lose delta as the underlying price fluctuates
Options lose extrinsic value as expiration approaches due to time decay (Correct answer)
Options become more volatile near expiration
Options require larger margin deposits over time

Correct 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.

Question 16: Which type of risk does a credit default swap (CDS) primarily transfer from buyer to seller?

Interest rate risk
Currency risk
Credit risk (Correct answer)
Liquidity risk

Correct 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.

Question 17: After entering a pay-fixed, receive-floating swap on top of floating-rate debt, a company's combined debt is effectively:

Still floating, but at a lower spread
Fixed rate (Correct answer)
Zero-coupon until maturity
Indexed to credit spreads

Correct 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.

Question 18: In the context of derivatives, 'delta hedging' refers to:

Setting the portfolio delta equal to exactly 1.0
Continuously adjusting positions to maintain a delta-neutral portfolio (Correct answer)
Using delta to determine how many options to purchase for income
Eliminating all option Greeks simultaneously through a single trade

Correct 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.

Question 19: An airline enters a long oil futures contract to hedge fuel costs. Oil prices then fall significantly. The outcome is:

The airline profits from both the futures gain and lower spot fuel costs
The futures position generates a loss that offsets the benefit of lower fuel costs (Correct answer)
The airline benefits from lower costs with no impact from the futures contract
The futures contract is automatically cancelled when prices move against the position

Correct 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.

Question 20: Which of the following accurately describes a 'collar' options strategy?

Buying a call and selling a put with the same strike to create a synthetic long
Owning the underlying, buying a protective put, and selling a covered call (Correct answer)
Buying both a call and put with the same strike to profit from volatility
Selling both a call and put on the same underlying to collect premium

Correct 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.

Question 21: In a standard interest rate swap, the 'notional principal' refers to:

The actual cash amount exchanged between counterparties at inception
The reference amount used solely to calculate periodic interest payments (Correct answer)
The profit or loss realized by each party at swap maturity
The market value of the swap contract at any given point in time

Correct answer: The reference amount used solely to calculate periodic interest payments

The notional principal is a reference figure used to calculate interest payments; in most interest rate swaps, it is never actually exchanged between the counterparties.

Financial Risk Management Derivatives and Risk Hedging

What is the primary purpose of using derivatives for hedging?

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