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

Question 4

Collar

Answer 4

Buying put and selling call at the same price

Question 5

Put spread

Answer 5

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

Question 6

Seagull
Spread

Answer 6

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 7

Cross hedge

Answer 7

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

Question 8

Macro hedge

Answer 8

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

Question 9

Synthetic long forward position

Answer 9

Long call with short put

Question 10

Covered call

Answer 10

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

Question 11

Protective put

Answer 11

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

Question 12

Collar

Answer 12

Buy out of the money put and sell otm call

Question 13

Bull spread

Answer 13

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

Question 14

Bear spread

Answer 14

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

Question 15

Long calender spread

Answer 15

Buying longer dated options and selling shorter dated options

Question 16

What is long risk reversal

Answer 16

A risk reversal strategy is an options trading strategy used to hedge or speculate on the directional movement of an asset’s price. 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 17

Volatility smile

Answer 17

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

Question 18

Volatility skew

Answer 18

Implied volatility increases for more OTM puts and decreases for more OTM calls

Question 19

Who benefits in a variance swap?

Answer 19

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 20

Cash equitization/cash securitisation/cash overlay

Answer 20

Refers to purchasing index futures to replicate the returns that would have been earned by investing the cash in an index with risk and return characteristics similar to those of the portfolio

Question 21

Currency risk

Answer 21

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

Question 22

Basis point value

Answer 22

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

Question 23

Long position of fra

Answer 23

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

Question 24

Payer swap

Answer 24

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

Question 25

Receiver swap

Answer 25

Receive fixed pay floating

Question 26

Issues with developing market currencies

Answer 26

• 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 27

Cross hedge/proxy hedge

Answer 27

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

Question 28

Minimum variance hedge ratio

Answer 28

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 29

Roll yield in currency

Answer 29

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 30

Economic fundamentals - currency

Answer 30

In the long term, currency value will converge to fair value

Question 31

Currency management strategies

Answer 31

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

Question 32

Bull call spread

Answer 32

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

Question 33

When to use bear spread

Answer 33

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 34

when to use Straddle

Answer 34

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 35

What is basis risk?

Answer 35

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 36

Forward rate bias

Answer 36

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 37

Covered call
- gain
- loss
- breakeven

Answer 37

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 38

Protective put
- gain
- loss
- breakeven

Answer 38

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