Financial Risk Management Derivatives and Risk Hedging 3

Question 1

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

Accepted Answer

Options lose extrinsic value as expiration approaches due to time decay

Answer

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

Question 2

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

Accepted Answer

Credit risk

Answer

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 3

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

Accepted Answer

Fixed rate

Answer

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 4

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

Accepted Answer

Continuously adjusting positions to maintain a delta-neutral portfolio

Answer

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 5

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

Accepted Answer

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

Answer

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.

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Derivatives and Risk Hedging 3