IMC Financial Analysis & Derivatives 3

Question 1

What is 'theta' in options pricing?

Accepted Answer

The time decay of an option's value — the rate at which an option loses value as it approaches expiry

Answer

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?

Accepted Answer

Buying a put option and selling a call option on an existing equity holding, limiting both downside loss and upside gain

Answer

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?

Accepted 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

Answer

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?

Accepted 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

Answer

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?

Accepted Answer

The sensitivity of an option's price to changes in the implied volatility of the underlying asset

Answer

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.

IMC Practice Test

IMC Practice Test

IMC Financial Analysis & Derivatives 3