IMC Financial Analysis & Derivatives 3 — Questions and Answers
Question 1: What is 'theta' in options pricing?
- The option's exposure to interest rate changes
- The time decay of an option's value — the rate at which an option loses value as it approaches expiry (Correct answer)
- The option's sensitivity to volatility changes
- The option's correlation with the market
Correct answer: The time decay of an option's value — the rate at which an option loses value as it approaches expiry
Theta represents the rate at which an option's time value erodes as time passes, all else equal. Options lose value as expiry approaches because there is less time for the underlying to move favourably. Theta is particularly significant for short-dated options.
Question 2: What is a 'collar strategy' in equity portfolio hedging?
- A strategy involving buying a bond to protect equity positions
- Buying a put option and selling a call option on an existing equity holding, limiting both downside loss and upside gain (Correct answer)
- A leveraged long strategy using options
- Hedging currency risk on an equity portfolio
Correct answer: Buying a put option and selling a call option on an existing equity holding, limiting both downside loss and upside gain
A collar involves owning the underlying, buying a protective put (limits downside), and selling a call (gives up upside above the call strike) to fund the put. It creates a range of outcomes — hence 'collar' — limiting both maximum loss and maximum gain.
Question 3: What is 'basis risk' in hedging?
- The risk that a hedge is too expensive to maintain
- The risk that the hedge does not perfectly offset the risk being hedged due to differences between the hedging instrument and the underlying exposure (Correct answer)
- The risk that the hedger lacks the expertise to hedge
- The regulatory risk of using derivatives for hedging
Correct answer: The risk that the hedge does not perfectly offset the risk being hedged due to differences between the hedging instrument and the underlying exposure
Basis risk arises when the hedging instrument (e.g., a futures contract) does not perfectly track the exposure being hedged (e.g., the specific equity portfolio). Differences in composition, timing, or specification mean the hedge may not fully eliminate the risk.
Question 4: What is a 'credit default swap' (CDS) and its primary use?
- A swap of fixed for floating credit returns
- A derivative contract where the buyer pays periodic premiums to the seller in exchange for compensation if a specified credit event (default) occurs — used for credit risk hedging or speculation (Correct answer)
- A swap of corporate bonds for government bonds
- A product for exchanging different currencies' credit ratings
Correct answer: A derivative contract where the buyer pays periodic premiums to the seller in exchange for compensation if a specified credit event (default) occurs — used for credit risk hedging or speculation
A CDS provides protection against credit events (default, restructuring) on a reference entity. The buyer pays regular premiums; if a credit event occurs, the seller compensates the buyer. CDS are used to hedge credit risk or to take views on creditworthiness.
Question 5: What is 'vega' in options risk?
- The sensitivity of an option's price to changes in the risk-free interest rate
- The sensitivity of an option's price to changes in the implied volatility of the underlying asset (Correct answer)
- The sensitivity of an option's price to changes in the underlying asset price
- The sensitivity of an option's price to changes in time
Correct answer: The sensitivity of an option's price to changes in the implied volatility of the underlying asset
Vega measures how much an option's price changes for a 1% change in implied volatility. A high vega option benefits significantly from rising volatility. Vega is highest for at-the-money options with longer time to expiry.
Question 6: What is a 'swap' in financial derivatives?
- An immediate exchange of assets at current market prices
- An agreement between two parties to exchange sequences of cash flows for a specified period, based on agreed parameters (Correct answer)
- An option to swap one currency for another
- A futures contract on a basket of assets
Correct answer: An agreement between two parties to exchange sequences of cash flows for a specified period, based on agreed parameters
A swap is an OTC derivative agreement where two parties exchange cash flow streams over a specified period. Common types include interest rate swaps (fixed for floating), currency swaps, and total return swaps. They are used for hedging or expressing market views.
IMC Financial Analysis & Derivatives 3
What is 'theta' in options pricing?