Financial Risk Management Derivatives and Risk Hedging 1 — 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.
Financial Risk Management Derivatives and Risk Hedging 1
What is the primary purpose of using derivatives for hedging?