Financial Risk Management Derivatives and Risk Hedging 2 — Questions and Answers
Question 1: 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 2: 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 3: 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 4: 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 5: 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 6: '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 7: 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.
Financial Risk Management Derivatives and Risk Hedging 2
A company with floating-rate debt enters a pay-fixed, receive-floating interest rate swap.
This hedge protects against: