Derivatives

Question 1

What is a long straddle

Answer 1

When you buy both put and call options at same exercise price
This is when you expect volatility to increase

Question 2

Define short straddle

Answer 2

When you sell both put and call
This is when you expect volatility to decrease

Question 3

Strangle

Answer 3

While straddle purchases at the money,
This purchases out of the money. used for more extreme volatility

Question 4

Put spread

Answer 4

Buy OTM puts and sell puts that are further out of the money

Question 5

Seagull
Spread

Answer 5

A put spread combined with selling a call (eg - buy a 35 delta put, sell a 25 delta put and sell a 35 delta call

Question 6

Cross hedge

Answer 6

Hedging with an instrument that is not perfectly correlated with the exposure being hedged

Question 7

Macro hedge

Answer 7

Addresses portfolio wide risk factors rather than the risk of individual portfolio assets

Question 8

Synthetic long forward position

Answer 8

Long call with short put

Question 9

Covered call

Answer 9

Long spot and sell call
When you think stock has limited upside potential

Question 10

Protective put

Answer 10

Buying stock plus put
For investor buying stock and protecting it from going down

Question 11

Collar

Answer 11

Buy out of the money put and sell otm call and also buy a stock

Question 12

Bull spread

Answer 12

Long options on the lower strike and short options on the higher strike

Question 13

Bear spread

Answer 13

Short options on the lower strike and long options on the higher strike

Question 14

Long calender spread

Answer 14

Buying longer dated options and selling shorter dated options

Question 15

What is long risk reversal

Answer 15

A risk reversal strategy is an options trading strategy used to hedge or speculate on the directional movement of an asset’s price. (usually for implied volatility skew) It involves simultaneously:

Buying a call option: Gives the trader the right to buy the underlying asset at a specified price (strike price), allowing them to benefit if the asset’s price rises.
Selling a put option: Obligates the trader to buy the underlying asset at a specified price if assigned, allowing them to reduce or offset the cost of the call.

This strategy is commonly used by investors who expect the price of the underlying asset to increase.

Question 16

Volatility smile

Answer 16

Where the further from ATM options have higher implied volatilities.
We would see a U shaped curve

Question 17

Volatility skew

Answer 17

Implied volatility increases for more OTM puts and decreases for more OTM calls, as the strike price moves away from the current
price.

Question 18

Who benefits in a variance swap?

Answer 18

The party receiving the variable payment (the purchaser) will gain on the contract when the realised variance is greater than the implied variance and vise versa

Question 19

Cash equitization/cash securitisation/cash overlay

Answer 19

Cash equitization is a strategy used by portfolio managers to ensure that any unintended cash holdings in a portfolio are actively contributing to returns, rather than sitting idle. It is typically done using stock index futures and interest rate futures.

Question 20

Currency risk

Answer 20

The exposure of foreign currency denominated assets and liabilities to changes in exchange rates

Question 21

Basis point value

Answer 21

The expected change in the value of a security or portfolio given a one basis point change in yield

Question 22

Long position of fra

Answer 22

Will receive a payment at settlement if the market rate of interest is higher than the forward rate specified in the FRA

Question 23

Payer swap

Answer 23

Contract to make a series of fixed rate payments and receive floating rate payments

Question 24

Receiver swap

Answer 24

Receive fixed pay floating

Question 25

Issues with developing market currencies

Answer 25

• low trading volume leads dealers to charge larger bid asked spreads
• for exit trade liquidity can be lower and transaction cost can be higher
• transactions between 2 emerging market currencies can be even more costly
• they are at a forward discount
• governments are highly involved in the pricing of the currency

Question 26

Cross hedge/proxy hedge

Answer 26

Refers to hedging with an instrument that is not perfectly correlated with the exposure being hedged

Question 27

Minimum variance hedge ratio

Answer 27

A mathematical approach to determining the hedge ratio

When to currency hedging it is a regression of the past changes in value of the portfolio to the past changes in value of the hedging instrument to minimize the value of the tracking error between these two variables

Question 28

Roll yield in currency

Answer 28

A return from the movement of the forward price over time towards the spot price of an asset

Profit or loss on a forward or futures contract if the spot price is unchanged at contract expiration

Question 29

Economic fundamentals - currency

Answer 29

At the heart of this approach is the assumption that, in a flexible exchange rate system, exchange rates are determined by logical economic relationships and that these relationships can be modeled.
The simple economic framework is based on the assumption that in the long run, the real exchange rate will converge to its “fair value,” but short- to medium-term factors will shape the convergence path to this equilibrium.

Question 30

Currency management strategies

Answer 30

• Passive hedging
• Discretionary hedging
• Active currency management
• currency overlay

Question 31

Bull call spread

Answer 31

buy the call option at a lower strike price and sell the option at a higher strike price

Question 32

When to use bear spread

Answer 32

Investors use a bear spread strategy to profit from an expected moderate decline in the price of an underlying asset while limiting both their potential risk and reward. Bear spreads are particularly appealing for traders who have a bearish outlook but do not anticipate a large or rapid drop in price.

Question 33

when to use Straddle

Answer 33

High Expected Volatility: You anticipate that the underlying asset will make a large move, either up or down, such as before earnings announcements or major news events.

Uncertain Direction: You believe the price will move significantly but are unsure whether it will rise or fall.

Question 34

What is basis risk?

Answer 34

Basis risk arises when the price movements of a hedging instrument do not perfectly correlate with the price movements of the exposure being hedged. This misalignment creates a risk that the hedge will not fully offset the changes in value of the underlying exposure.

Question 35

Forward rate bias

Answer 35

Forward rate bias in the currency market means that the forward exchange rate (the agreed-upon rate to trade currencies in the future) is not a perfect predictor of the actual exchange rate that will happen in the future. In fact, it often deviates in a way that can be somewhat predictable.

Question 36

Covered call
- gain
- loss
- breakeven

Answer 36

Maximum gain = (X − S0) + c0
Maximum loss = S0 − c0
Breakeven price = S0 − c0
Expiration value = ST − Max[(ST − X),0]
Profit at expiration = ST − Max[(ST − X),0] + c0 − S0

Question 37

Protective put
- gain
- loss
- breakeven

Answer 37

Maximum gain = ST − S0 − p0 = Unlimited
Maximum loss = S0 − X + p0
Breakeven price = S0 + p0
Expiration value = ST + Max[(X − ST),0]
Profit at expiration = ST + Max[(X − ST),0] − S0 − p0

Question 38

when do you use collar

Answer 38

Used to manage risk in an investment portfolio by limiting both potential losses and gains within a predefined range. This strategy is often employed by investors who want to protect an existing position or lock in gains while reducing the cost of downside protection.

Question 39

Calendar spread

Answer 39

A calendar spread (or time spread) is an options trading strategy that involves buying and selling options with the same strike price but different expiration dates. Typically, the option with the longer expiration is bought, and the one with the shorter expiration is sold.

Question 40

implied volatility

Answer 40

Expected volatility an underlying asset’s return and is derived from an option pricing model

Question 41

In currency, why are forward contracts preferred over futures?

Answer 41

1) Futures contracts are standardized in terms of settlement dates and contract
sizes. (not much flexibility)
2) Futures contracts may not always be available in the currency pair that
the portfolio manager wants to hedge.
3) Futures contracts require up-front margin (initial margin).

Question 42

Short seagull spread in currency

Answer 42

Buy an ATM put.
Write an OTM put.
Write an OTM call.

Question 43

Long seagull spread

Answer 43

Write an ATM call
Buy an OTM put
Buy an OTM call

Question 44

Knock in options (currency)

Answer 44

Becomes active only if the spot rate reaches a pre-specified barrier.

Question 45

knock out options (currency)

Answer 45

Terminates if the spot rate reaches a pre-specified barrier.

Question 46

binary options (currency)

Answer 46

Provides a fixed payout if the spot exchange rate is in-the-money.
Unlike vanilla options, where the payoff depends on the difference between the spot and strike price, digital options offer an all-or-nothing outcome.

Question 47

transaction on cash settles equity swap

Answer 47

If the swap is cash settled, on the termination date of the contract the
equity swap receiver will receive (pay) the equity appreciation (depreciation) in cash.

Question 48

Physically settled equity swap

Answer 48

If the swap is physically settled, on the termination date the equity swap receiver will receive the quantity of single stock specified in the contract and pay the notional amount.

Question 49

bull call spread
- profit
- break even
- loss

Answer 49

Profit=min(Underlying Price − K1,K2 − K1) − Net Premium Paid

Max profit: K2 − K1 − Net Premium Paid

Max loss: the net premium paid.

Breakeven=K1+Net Premium Paid

Question 50

bear put ke formulaes

Answer 50

Max profit: K1−K2−Net Premium Paid.

Loss=Net Premium Paid

Breakeven=K1−Net Premium Paid

Question 51

Straddle ke formulaes

Answer 51

if price rises above K (upside)
Underlying Price−K−Total Premium Paid

​if price falls below K (downside)​
K−Underlying Price−Total Premium Paid

Loss=Total Premium Paid

Breakeven (Upside)
K+Total Premium Paid

Breakeven (Downside)
K−Total Premium Paid

K=strike price

Question 52

Profit in a collard strategy

Answer 52

Π = X1 − S0 − p0 + c0
if ST ≤ X1
Π = ST − S0 − p0 + c0
if X1 < ST < X2
Π = X2 − S0 − p0 + c0
if ST ≥ X2

Question 53

Equity swaps (liquidity)

Answer 53

Illiquid, OTC, voting right do not confer to the counterparty receiving the performance of underlying

Question 54

Define basis

Answer 54

Basis is the difference between spot price and futures price
= Spot price - futures price

if +ve basis, sell it. i.e., buy the bond and sell the futures and vice versa for negative

Question 55

When call volatility is higher than Put volatility

Answer 55

a short risk reversal strategy buying the put and writing the call

Question 56

What is a bear put

Answer 56

It involves buying a put option at a higher strike price and selling a put option at a lower strike price, both with the same expiration date.